Credit Cards

This page is intended mainly as part of the NextCard case. However, it can also be read as a standalone note on the credit card industry.

How Credit Cards Work

To borrow the metaphor used by Evans and Schmalensee (1999), there are many "characters" in the credit card story. Here are some of the main ones, with an account of the part each plays in making credit cards work.

Systems

Systems, such as Visa and Mastercard, are actually joint ventures between the issuing institutions. Not all cards issued by Visa and Mastercard are credit cards. Many such cards, particularly in Europe, are debit cards, linked directly to the cardholders' bank accounts.

Issuing Institutions

Issuing institutions, such as NextCard, MBNA, and Citibank, collect money from both the cardholder and the merchant. For example, many cards charge annual fees to cardholders; all charge interest to cardholders who do not pay off their balances in full each month, unless they are running a particularly generous promotion. If you use an Citi Mastercard to buy from the Northeastern University bookstore, the store (merchant) gives around 2% of the transaction value to Citi (issuing institution).

By visiting the "about us" pages of their respective web sites, you can see a major differences between the two largest credit card issuers in the U.S.: Citi and MBNA. A key similarity is that both are banks. However, there are large nonbank issuers, such as AT&T and GM.

Affiliates

Amazon were affiliated with NextCard, as we can see if we look at the now-useless credit cards which bear the name of Amazon, the affiliate, as well as the names of NextCard (issuer) and Visa (system). Cards like this are called cobranded cards or affinity cards. There are two advantages to being an affiliate.

• Payment from the issuing institution. NextCard paid Amazon for each customer holding an Amazon Visa card issued by NextCard.
• Increased loyalty from the cardholder. Amazon points, earned by using the card, made cardholders more likely to shop at Amazon in future. Of course Amazon had to buy this loyalty with points and hence with gift certificates.

Note that it is quite possible, and not uncommon, for the same organization to be both merchant and affiliate for a given transaction; this was the case when I used my Amazon Visa at Amazon.com, but not when I used it at another other store.

The U.S. Credit Card Industry

Dolores Smith (2001), the director of the Federal Reserve Board's Division of Consumer and Community Affairs, testified to a House of Representatives subcommittee that:

Recent estimates suggest that in 2000, consumers used about 1.4 billion credit cards (or roughly 9 cards per holder) to purchase nearly 1.5 trillion dollars in goods and services in more than 20 billion individual transactions. It is estimated that at year-end 2000, consumers in the U.S. owed nearly $675 billion on general purpose credit cards.

In 1998, 67.6% of families had at least one bank-type credit card (Kennickell, Starr-McCluer, & Surette, 2000. In the Survey of Consumer Finances in which this statistic appears, individuals are considered families. Bank-type cards include Visa and Mastercard. At the time of writing, the reports on the consumer finance data collected in 2001 are in preparation). This represents a slight increase from 1995, when 66.5% of families had such cards. The percentage of households with at least one credit card quadrupled between 1970 and 1995 (Evans and Schmalensee, 1999).

According to Evans and Schmalensee (1999), the U.S. credit card industry is characterized by:

• Rapid growth, as described above.
• Concentration at the system level (Mastercard and Visa dominate).
• A large number of competitors at the issuer level, with no few issuers dominating. In terms of 1997 bankcard charge volume, the largest issuer was Citibank (15.16%), followed by MBNA (9.36). However, there is a trend towards consolidation.
• High risk for issuers. Issuers offer to cardholders unsecured loans of indeterminate duration. Chargeoffs (amounts owed by cardholders to issuers, but deemed uncollectable) are the second-highest cost (32% of issuer costs in 1996), behind only cost of funds (40%). Issuer profitability declined from 1999 to 2000, with provisions for future losses accounting for much of the decline (Board of Governers, 2001).
• Intense competition between issuers. (Since this page serves mainly as part of the NextCard case, identification of the way in which issuers compete for customers is a matter for class discussion, rather than for description here.)

Select Bibliography

The web pages linked to above should be considered part of this bibliography, as well as part of the case.

If, after reading the above, you are finding the workings of credit cards hard to understand, take a look at the HowStuffWorks and Media Open descriptions. Apart from that, the links and citations below are for reference; you don't need to follow them up in order to analyze the NextCard case. All links are live as of January 17, 2003.

Bankrate.com. 2002. Credit cards. Includes a glossary of terms and other consumer-oriented information.

Board of Governers of the Federal Reserve System. 2001. The profitability of credit card operations of depository institutions.

Edgar, Dunn & Company. 2002. The US consumer credit market: Trends and perspectives. Available online.

Evans, D.S., & Schmalensee, R. 1999. Paying with plastic. Cambridge, MA: MIT Press.

HowStuffWorks. How credit cards work.

Kennickell, A.B., Starr-McCluer, M. & Surette, B.J. 2000. Recent changes in U.S. family finances: Results from the 1998 Survey of Consumer Finances. Federal Reserve Bulletin, 86: 1-29. Available online.

Media Open. Learn about credit cards.

Manning, R.D. 2000. Credit card nation. New York: Basic. A far less favorable account of the industry than Evans and Schmalensee's.

Smith, D.S. 2001. Testimony. November 1. A recent account of growth in the industry.

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