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There's an old saying: "You have to spend money to make money." That old maxim often gets trotted out to encourage small business owners to invest in their own businesses. But as it turns out, the advice is just as useful for huge Wall Street banks trying to drum up greater business for their credit card divisions.
In the aftermath of the financial crisis, banks have explored various avenues to try to push their profits up toward the levels they enjoyed during the housing boom. One tactic some banks have come up with involves scaling back on credit card reward programs. But as a recent study shows, that strategy may actually cost banks some extra revenue.
A smart investment
Researchers from the Federal Reserve Bank of Chicago recently looked at how much of an impact credit card reward programs have on cardholder behavior. What their study found is that when a credit card company offers a 1% cashback reward, it ends up having to pay out around $25 every month to their cardholders. But it also increases spending by an average of $68 per month -- and increases debt levels by an even-greater $115 each month.
Interestingly, the researchers took their study a step further, trying to figure out whether the additional spending came from people switching their purchases from other credit cards. The conclusion they drew is that not only did some switching take place but cardholders' absolute spending likely went up, as well.
That additional spending creates more profit opportunities for banks. Citigroup (NYSE: C ) , Bank of America (NYSE: BAC ) , and JPMorgan Chase (NYSE: JPM ) earn substantial revenue from interchange fees on the credit cards they issue, and additional spending on rewards cards would provide a larger base on which to charge their interchange percentages.
Turning their backs on opportunity
Yet banks have largely moved in the other direction lately, de-emphasizing rewards cards. JP Morgan Chase, Citigroup, and Discover Financial (NYSE: DFS ) have started making rewards more difficult to qualify for, with programs that require repeatedly signing up for changing categories of spending. Last year, American Express (NYSE: AXP ) started charging higher penalties and fees on some of its rewards cards.
Part of the pressure may be coming from the fact that, overall, consumers have gotten their balance sheets in better shape lately. According to the Federal Reserve, outstanding debt on credit cards and other revolving debt accounts has shrunk by 17% since the end of 2008 and is on track to post its fifth straight quarterly drop.
But even though outstanding debt is down, the amount of spending has stayed healthy. JPMorgan Chase reported 6.6% higher spending in its credit card unit during the third quarter. The disconnect may come from the fact that defaults have forced credit card companies to write down uncollectible card accounts, reducing outstanding debt but not really reflecting any change in consumer behavior going forward.
A no-lose investment?
Higher spending doesn't just help credit card companies. It also benefits Visa (NYSE: V ) and Mastercard (NYSE: MA ) , the networks that most Wall Street banks use for their cards. And from an investing perspective, Visa and Mastercard have an advantage over issuing banks: No matter which bank wins the cutthroat credit card wars, the network companies stand to benefit from the higher spending that results. As long as the competitive environment for credit cards doesn't lead to less use, then both Mastercard and Visa will be well-positioned to profit.
Despite the negative impact of credit card reform on their bottom line, banks still rely on their credit card business to generate profits. If banks don't want to kill the goose that lays their golden eggs, they'll realize that encouraging card use through rewards -- rather than nickeling and diming customers with higher fees -- will earn them not only more money but also customer loyalty. That's a commodity that scandal-torn banks could use right now.
Instead of paying big interest rates on credit cards, invest in a stock that will pay you back. Anand Chokkavelu wants to show you the dividend stock Warren Buffett would buy if he were you.