The credit card profit model can be complex, however, at its core - the model is one of the simplest there is. For new risk managers and strategists or product managers, this is a place to start. It should provide a framework to help one think through how a risk or marketing strategy impacts the levers that result in revenue or expense changes and hence the overall profits.
For starters, we all understand profit - the difference between the revenue and the amount spent in buying, operating, or producing something. From an issuer point of view - and especially a financial services firm - a more apt definition of profit is -
Profit = Revenue - Expense
Where:
Expense = Bad Debt + Capital Cost + Fixed Costs + Variable Costs
Few terms above - for instance, Bad Debt, Revenue and Fixed Costs will need to be broken down further into their drivers. So let’s start with the revenue drivers.
Revenue Drivers:
This is an easy one - we all have at least one credit card in our pocket - we know outside of the amount we charge on the card we pay - interest on the balance we carry, we pay an annual fee or we pay foreign transaction fee (for cards used outside the country), and if you are a business owner who accepts credit cards you would also know about the interchange or swipe fee the bank charges.
So in simplest terms three broad categories
- Interest income from customers
- Fee income from customers (annual fee, foreign exchange fee, balance transfer fee, late fee, over-line fee)
- Interchange fee from businesses
To introduce another concept, the customer behavior directly impacts the kind of revenue the card issuer will realize. Transactors - people who transact and pay their balance in full - will result primarily non interest income. While Revolvers - people who carry balances and don't pay down in full will drive up the interest income component of revenue. It is obvious given the behavior, one of the above two segments (revolver) is inherently riskier. They have the potential to drive up the bad debt rate, and will also be associated with higher capital costs. There might be multiplestrategies to mitigate these rises - for instance the issuer might encourage the Transactors to revolve (via - balance transfer offers or teaser rates to encourage large ticket purchases). It is also important to understand the impact this will have on the fee income, primarily on interchange fee. One group will inherently result in lower interchange fee than the other. From a marketing and product design perspective, the behavior of the two groups above is important as - not only would the programs be aimed towards different risk buckets (ex - FICO / Life Time Loss bands) but one of the two groups will be rate agnostic and more interested in rewards associated with the card.
Going back to the Revenue equation -
Revenue = Fee Income + Interest Income + Merchant Swipe Fee
Where
Fee Income = ( Annual Fee ) * ( Number of Card Holders)
Interest Income = (Average Revolving Balance) * (Interest Rate Margin) = [(# of Transactions) * (Average Transaction Size) * ( Percentage of Revolvers)] * (Interest Rate Margin)
Merchant Swipe Fee = (Total Transaction Volume) * (Interchange Fee %) = [(# of Transactions) * (Average Transaction Size)] * (Interchange Fee %)
Next - Let’s look at the Expense Drivers.
Expense Drivers:
As expected of any business model there are fixed costs and variable costs. Fixed costs for the most part are similar to most other businesses, in fact few costs that might be variable costs in the long run can potentially be fixed in the short term, for instance we might originate a certain vintage of loans with poor credit quality - we might not necessarily have to increase our collection expense, but if the trend continues and volume of poor credit origination continue to grow the cost to collect would go up to. Nevertheless, looking back at Variable costs - one of the biggest drivers of variable cost for Credit card firms is - the interest free period - during with the firm incurs the cost of the debt. The channel through which the customer is acquired also drives the expense structure, online vs in branch acquisition. The credit grade of the customer - drives the systemic auto approval or manual decisioning both resulting in different costs.
Other major drivers of cost can be - credit losses and operational losses (usually fraud losses). The fraud could be through any channel, online purchase, point of sale purchase etc. Simplest way to quantify this is through historic data.
Finally one of the remaining biggest components is the rewards program. These rewards programs have a cost associated with them. They have thresholds associated with them, hence this can be viewed as "net fee", i.e. cost of reward less fee associated with the transaction.
Let’s quantify the main costs - first comes Interest free period
Variable Cost = Cost associated with Interest Free Period + Cost of Loyalty program + Operational Cost or Fraud loss
Where:
Variable Cost = (Total Transaction volume * Cost of Capital * Interest free duration adjustment ) + (Total Transaction volume * Effective Loyalty cost) + (Total Transaction volume * Fraud Rate) = [(# of Transactions) * (Average Transaction Size) * {[(Cost of Capital) * (Interest Free duration adjustment)] + Effective Loyalty cost + Fraud Rate}
Finally the Profit Equation:
Profit = Revenue - Expense = Revenue - Bad Debt - Capital Holding Costs - Fixed Costs - Variable Costs
Where:
Revenue = ( Annual Fee ) * ( Number of Card Holders) + [(# of Transactions) * (Average Transaction Size) * ( Percentage of Revolvers)] * (Interest Rate Margin) + [(# of Transactions) * (Average Transaction Size)] * (Interchange Fee %)
Bad Debt = Current Outstanding $'s * Bad Rate = Credit Limit * Utilization * Loss Rate
Capital Holding Cost = Cost for utilized dollars + Cost to cover un-utilized dollars = (Credit Limit * Utilization rate * Cost of Capital) + [(Credit limit) * (1-Utilization rate) * (Basel Holding Rate) * (Cost of Capital)]
While what I have detailed above is a highly simplified version of the profit equation, understanding the levers should help understand how various origination strategies and account management strategies impact the profitability of the overall credit card business.
