Credit Card Rewards: A $15 Billion Transfer of Wealth, New Research Says
Credit Card Rewards: A $15 Billion Transfer of Wealth, New Research Says
Fed Declines Custodia's Membership Bid, Prosecutors Seize $150m in FTX Funds From Silvergate & Moonstone
Hey all, Jason here.
We’re somehow already nearly at the end of January — one of my least favorite months. I find that post-holiday period, especially living in a cold(ish) climate, a real struggle some times.
But, thankfully, work has kept me plenty busy — and there are multiple exciting events in the near future. Kicking off “conference season” with Banking Renaissance Retreat here in Amsterdam late next month, before heading to Las Vegas in March for Fintech Meetup and NYC in April for New York Fintech Week.
Have a couple exciting things cooking around these events, so stay tuned for full details!
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Credit Card Rewards Are A $15 Billion Transfer Of Wealth, Widen Existing Disparities, New Research Paper Argues
The US credit card market is unique in a number of ways, but one aspect will be particularly salient for anyone who has spent much time working in or analyzing the sector: the key role “rewards” play in attracting, retaining, and, yes, monetizing consumers.
There are card card rewards programs that cover seemingly every sector imaginable, from simple cash back programs to classic airline mileage programs to retailers, auto manufacturers, and even crypto rewards.
A simple mental model to understand how card issuers pay for rewards understandably focuses on interchange: “premium” cards that pay higher rewards (think Amex cards or Chase Sapphire Reserve) charge higher interchange. Cards with less lucrative rewards or “classic” cards with no rewards programs typically carry lower interchange rates.
An understanding of the market structure of rewards grounded in this model supports an argument that rewards programs effectuate a transfer of wealth from lower-income shoppers to higher-income consumers.
The basic (and not incorrect) logic being that merchants generally charge consumers a set price, regardless of how they are paying (with few but increasing exceptions.) Merchants set prices that incorporate their payment processing costs.
While buyers paying with cash (no interchange) or debit (low interchange) pay the same price as those paying with a rewards credit card (higher interchange), the cash/debit shopper gets no reward on the backend, while the rewards card user does.
Because cash/debit users skew lower income and rewards cards users skew higher income, lower-income shoppers are effectively subsidizing the rewards of higher-income consumers.
Rewards Are Subsidized By Low FICO “Naive” Consumers, Paper Argues
While a new academic research paper published in December acknowledges the transfer from cash/debit users to rewards card users, it argues that a more significant cross subsidy takes place between credit card users.
Specifically, the paper’s headline finding is that use of rewards card drives “an aggregate annual redistribution of $15 billion from less to more educated, poorer to richer, and high to low minority areas, widening existing disparities.”
The authors explore losers vs. gainers in this redistribution along multiple axises — FICO credit score, income, geography, etc. — by looking at cardholders’ monthly “net reward,” which they define as the dollar value of rewards minus interest and fee payments. “Classic credit cards,” or those that do not include a rewards component, form a benchmark for comparison.
The paper uses FICO score as an indicator of “financial sophistication” — interpreting consumers with low FICO scores as financially “naïve” vs. higher FICO consumers as being financially “sophisticated.” While some of the analysis supports this characterization — like rates of payment misallocation — it oversimplifies drivers of lower credit scores and is a bit reductive.
Still, the analysis reveals a number of interesting dynamics.
Examining the distribution of rewards by FICO score, the authors find the distribution of rewards is heavily tilted towards those with prime/super prime credit scores.
The authors don’t really explain why this would be the case, though given that rewards are typically a function of the amount spent on a card, it is reasonable to conclude higher FICO cardholders spend more on their cards and thus earn more in gross rewards:
However, when looking at interest charges as a function of FICO score, the authors find that sub- and near-prime rewards card holders, unsurprisingly, pay significantly more in interest charges each month than higher FICO card holders.
Perhaps more interestingly, sub- and near-prime rewards card holders also pay significantly more than users of matching credit profiles who use “classic” (non-rewards) credit cards:
Why would it be the case that similar credit risk borrowers incur significantly greater interest charges when using a rewards card vs. a classic card?
The paper acknowledges anecdotal evidence that rewards cards induce greater spending and attempts to provide further insight on this question by looking at how users of rewards cards vs. classic cards respond to bank-initiated credit limit increases.
The authors find that cardholders’ spending increases on rewards cards is materially higher in response to a credit limit increase than on classic cards — and this is true across the FICO spectrum.
However, as prime- and super-prime consumers spend more in response to limit increases, they also increase their repayment amounts; whereas near- and sub-prime consumers do not meaningfully increase their repayment amounts.
This suggests that near- and sub-prime cardholders are more likely to over-spend and thus over-borrow on rewards cards vs. classic cards.
The authors also demonstrate lower FICO consumers are more likely to “misallocate” payments and thus incur higher interest charges than higher FICO consumers.
Instead of making the minimum required payment on all cards and allocating any additional payment to card(s) with the highest interest rate, lower FICO cardholders are more likely to follow a “balance-matching” heuristic, where their payment amount is driven by the balance owed (rather than interest rate) or to make equal payments across all cards.
The authors find these kinds of sub-optimal payment allocations are more likely for rewards card users vs. classic card users.
Relatively Few Cardholders See Positive Economic Outcome From Rewards Cards
The result of lower FICO users accruing fewer rewards but paying greater interest charges is that such cardholders achieve negative “net” monthly rewards — meaning the cost of interest and fees is greater than the rewards they earn.
Further, because of the greater likelihood of overspending and payment misallocation with rewards vs. classic cards, lower-FICO cardholders actually end up worse off using a rewards credit card vs. a classic card, the authors’ research demonstrates:
It’s only users with FICO scores above ~780 that achieve positive net rewards — suggesting that part of the cost of providing those rewards is borne by users with sub-780 FICO.
Notably, this trend remains true even when cardholders are segmented by income.
Higher income cardholders that have lower FICO scores actually have substantially worse negative net rewards than comparable credit quality users with mid- and low-income:
Logically, this is primarily driven by higher-income lower-FICO users carrying larger balances and thus incurring greater interest charges and, potentially, more frequent fee charges (eg, late fees if they’re “sloppy payers.”)
Banks Charge Lower Interest Rates But Achieve Better Profitability On Rewards Cards
The appeal of rewards cards to consumers is obvious — even if, in reality, they are utility-destroying for many users.
But how do the cost of rewards and consumers’ usage and payment habits when using rewards cards vs. classic impact banks’ profitability?
The authors find that rewards cards are significantly more profitable than classic cards across the FICO spectrum:
Rewards cards are more profitable than classic cards even when taking into account the cost of the rewards and that banks offer lower interest rates on such cards.
Lower APRs on rewards cards serve both as an enticement for consumers to chose the card vs. a classic card and a potential contributor to the overspending and over-borrowing that is more common on rewards vs. classic cards:
A $15 Billion Transfer Of Wealth
Analysis estimates the total annual value of rewards redistribution at $15 billion.
While much of the analysis segments cardholders by FICO score, credit score has meaningful correlations with other consumer attributes, including income, educational attainment, financial “sophistication,” race, geographic location, and so on.
The authors thus argue that “[t]hese results suggest that credit card rewards are a potential channel that can exacerbate existing socio-economic disparities across regions in the United States, as they imply a transfer from less to more educated, from poorer to richer, and from high- to low-minority areas, thereby widening existing spatial disparities.”
Fed to Custodia: No Membership, Master Account For You
In the latest twist in the crypto bank/Fed master account saga, the Federal Reserve Board unanimously voted to deny Custodia’s (formerly known as Avanti) bid to become a member of the Federal Reserve System — thus blocking the bank’s goal of obtaining a Fed master account and direct access to Fed payment systems.
The board has not yet released the full text of its order denying Custodia’s application, though it said in part in a statement (emphasis added and spacing adjusted):
“The Board has concluded that the firm’s application as submitted is inconsistent with the required factors under the law.
Custodia is a special purpose depository institution, chartered by the state of Wyoming, which does not have federal deposit insurance. The firm proposed to engage in novel and untested crypto activities that include issuing a crypto asset on open, public and/or decentralized networks.
The firm’s novel business model and proposed focus on crypto-assets presented significant safety and soundness risks. The Board has previously made clear that such crypto activities are highly likely to be inconsistent with safe and sound banking practices.
The Board also found that Custodia’s risk management framework was insufficient to address concerns regarding the heightened risks associated with its proposed crypto activities, including its ability to mitigate money laundering and terrorism financing risks.”
For those less familiar with some of the peculiarities of the United States’ dual state/federal banking system, Bank Reg Blog has a great analysis of the implications of Custodia’s denial, including this helpful background:
“In the United States banks may be chartered either at the state level or at the federal level.
If a bank is chartered at the federal level it is supervised by the Office of the Comptroller of the Currency. All national banks are members of the Federal Reserve System.
If a bank is chartered at the state level, it may elect to become a member of the Federal Reserve System, in which case it is called a member bank and is supervised by the Federal Reserve Board.
A state-chartered bank may also elect not to become a member of the Federal Reserve System. Such banks, called non-member banks, are supervised the Federal Deposit Insurance Corporation.
Permissible activities of national banks are determined by the National Bank Act and other federal laws, as well as regulations adopted by the OCC.
Permissible activities of state banks are determined by applicable state law, subject to the federal overlay described below.
Under Section 24 of the Federal Deposit Insurance Act (FDIA), an insured state bank generally may not engage as principal in any activity that is not permissible for national banks, unless authorized by federal statute or the FDIC.”
Basically, state-chartered uninsured banks — in theory — could become members of the Federal Reserve System without being bound by the restrictions of Section 24 of the FDIA.
The board’s policy statement would seem to significantly narrow this loophole in order to “level the playing field” and discourage regulatory arbitrage. Per the statement (emphasis added and spacing adjusted):
“[T]he Board generally believes that the same bank activity, presenting the same risks, should be subject to the same regulatory framework, regardless of which agency supervises the bank.
This principle of equal treatment helps to level the competitive playing field among banks with different charters and different federal supervisors, and to mitigate the risks of regulatory arbitrage.”
To address this potential gap, “the Board generally presumes that it will exercise its discretion under section 9(13) of the Act to limit state member banks to engaging as principal in only those activities that are permissible for national banks.”
However, the Fed’s decision to decline its application apparently hasn’t dissuaded Custodia. Per a comment from Custodia’s founder and CEO Caitlin Long to Axios, while “surprised and disappointed” by the Fed’s decision, Custodia “will continue to litigate the issue.”
Prosecutors Seize $150 Million in FTX-Linked Funds from Silvergate, Moonstone
In the latest blow to banks that built businesses around serving crypto companies, federal prosecutors have seized funds from Silvergate and Moonstone (which recently reverted to using its Farmington State Bank name.)
According to reports in Reuters, the DOJ seized $94.5 million in cash from a Silvergate account associated with FTX Digital Markets, the company’s Bahamas subsidiary. Prosecutors seized an additional $7 million from other Silvergate accounts associated with Sam Bankman-Fried and FTX.
Moonstone, which recently announced it would end its plans to support cannabis and crypto businesses, also had FTX-related funds seized.
The DOJ seized $50 million in FTX funds from Moonstone on or around January 4th.
The loss of funds puts Moonstone in a precarious financial position. According to the banks most recent call report, it had about $64.5 million in deposits as of the end of 2022.
Losing the $50 million FTX had stashed at the bank would appear to draw Moonstone’s deposit base down to a paltry $14.5 million — about where it was at the end of 2021, before embarking on its crypto-and-cannabis journey.
Other Good Reads
The Future of Due Diligence in the Wake of FTX and Frank (Business Insider)
Bank of America’s And Chase’s Digital Wallet is DOA (Doomed on Announcement) (Ron Shevlin/Forbes)
Big Banks’ Next Big Bet (Fintech Takes)
Why Goldman Sachs Is Far, Far Behind Morgan Stanley (Washington Post)
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