The New York Times


August 23, 1992, Sunday, Late Edition - Final

HEADLINE: FORUM; Banks Play It Too Safe on Visa Cards

BYLINE: By BARRY NALEBUFF; Barry Nalebuff is a professor at the Yale School of Organization and Management and co-author of "Thinking Strategically."

There is an old saying: "You lose money on every transaction, but you make it up on the volume." It seems that some Visa-card issuers have actually taken this strategy to heart. Roughly one third of Visa card-holders are what the industry calls "maxpayers" -- people who pay their balance in full each month. A back-of-the-envelope calculation shows that a bank issuing the cards could lose $600 on each maxpayer over the lifetime of the account. That puts pressure on card issuers to keep interest rates high.

Visa-card issuers have an income from their cards, even if balances do not build up. For each dollar charged on a Visa card, the merchant pays a fee of about 2.15 percent, of which only about 1.4 percent goes to the issuing bank. The bank also charges an annual fee, which is usually about $50 for a card that accrues frequent flier miles.

But the perks offered on credit cards are expensive. Several banks offer a frequent-flier mile for each dollar charged. Although those miles trade at a penny a mile, I estimate the cost of frequent-flier miles, extended warranties, price guarantees and car-rental insurance at 0.9 percent of each dollar charged.

A second major expense is from the losses due to default and fraud. Maxpayers have the lowest default risk. Yet, the three major causes of default -- divorce, loss of job and health problems - all affect maxpayers. Although this number is the hardest to estimate, current default rates are over 4 percent of outstanding billings. As a result, I conservatively estimate default and fraud losses from maxpayers cost the issuer an additional 0.75 percent of each dollar charged.

Maxpayers also get an interest-free loan. If their purchases are spread out evenly and they take advantage of the grace period the card issuers offer, the average maxpayer gets a 27-day float. At the bank's cost of capital (8 percent), this adds 0.6 percent more to the costs on each sale.

Finally, billing, 24-hour customer service, emergency card replacement and other administrative expenses easily tack on $35 per year. Visa also charges issuing banks a 0.2 percent commission.

If all the costs are added up, the banks lose $15 a year, plus 1.05 percent on the value of each purchase. On an annual purchase volume of $6,000, the issuing bank is out $48 a year for a lifetime loss of more than $600 on each maxpayer. Even cards without frequent-flier miles lose money, since the annual fees are often much lower or waived altogether.

So why take these losses? Visa may simply be trying to capture market share and willing to pay the price. But banks don't have the same incentive to keep maxpayers.

The problem begins with the way most banks evaluate risk when they issue credit cards. Their focus is exclusively on whether a card-holder is likely to default, which is easy to measure and to predict. But the banks' real interest is whether a card-holder will be profitable. Banks use the wrong variable when issuing cards, and the cost of this mistake is that maxpayers look like the best customers.

Once maxpayers are in the door, they are easy to spot, though it may be awkward to get them out. Imagine the public relations effect of "We are discontinuing your credit card; you pay your bills on time."

One solution is to be more innovative in pricing the cards. Charge a high annual fee but make the fee a credit toward interest charges. People who use the card for credit won't pay any more money, while maxpayers will either voluntarily give up the card or pay a fee that justifies its cost. Another solution is to direct maxpayers to American Express. Both sides come out ahead. Visa stops losing money and American Express, with its higher annual fee and higher commission rate, profits from maxpayers.

As a maxpayer, it hurts me to suggest this shift in strategy. But once Visa issuers eliminate the maxpayer subsidy they can afford to lower interest rates to the people who really need to borrow.