Published in 1888, Bellamy’s book about achieving a utopian society was a huge best seller in its time.
“Perhaps you would like to see what our credit cards are like,” [Doctor Leete asks of his guest, Julian West]. “You observe…that this card is used for a certain number of dollars….The value of what I procure on this card is checked off by the clerk, who pricks out of these tiers of squares the price of what I order.” [Mr. West, from Boston, has awakened 113 years in the future, in the year 2000.”
– Edward Bellamy, Looking Backward, 2000-1887 (1888)
The simple payment card has been around since at least the beginning of the twentieth century. Hotels, oil companies, and department stores issued cards before World War I. In response to customer requests, Sears began offering lines of credit in 1910 to customers of “unquestionable responsibility,” although the Sears card came more than a decade later. Some large retailers gave cards to their wealthier customers that identified them as having a charge account with the store. By the 1920s, several department stores allowed cardholders to pay off their bills in monthly installments. Metal “charge-plates” with embossed consumer information were introduced by department stores in 1928. During the 1920s as well, oil companies issued “courtesy cards” for charging gas. By the end of World War II, charge cards were no longer a novelty, but they were about as far from the cards of today as barter was from coin.
Restaurants did not issue cards. In 1949, Frank McNamara, the president of a New York credit company, was having lunch in Manhattan. A year later, as we mentioned earlier, he had a thriving business based on this experience. He was written up in Newsweek two years later: “Halfway through his coffee, McNamara made a familiar, embarrassing discovery; he had left his wallet at home. By the time his wife arrived and the tab had been settled, McNamara was deep in thought. Result: the ‘Diner’s Club,’ one of the fastest-growing service organizations.” (This is the earliest rendition of the story we’ve found. One journalist several years later gave the credit to Alfred Bloomingdale, then the president of Diners Club, and changed the meal to dinner.)
Figure 3.1: Frank McNamara, the man who invented the modern card industry
Following McNamara’s epiphany, people began carrying charge cards in their wallets. McNamara and an associate, Ralph Schneider, started small. Beginning with $1.8 million of start-up capital, they signed up fourteen New York City restaurants and gave cards away to selected people. By the card’s first anniversary there were 42,000 cardholders, each paying $21 a year for membership in the “club.” And 330 U.S. restaurants, hotels, and nightclubs accepted these cards; they paid an average of 7 percent of the cardholder’s bill to Diners Club. In March 1951, Diners Club handled $3.5 million of exchanges between cardholders and merchants, and reportedly made about $70,000 in pretax profit. At that pace, it was handling $41.5 million in transactions annually.
Unlike store cards, Diners Club cards provided a broader medium of exchange—one that extended to at least all the merchants in the club. And it was more than money because consumers didn’t have to pay right away. (As always, we have adjusted figures to 2008 dollars. In this chapter we sometimes round figures and use “about” or “around” to signify that we’ve done so. We report a few figures from 2005 and later and these we do not adjust.)
Figure 3.2: One of the early cardboard Diners’ Club cards
That club expanded rapidly. In 1956, it had an annual transaction volume of more than $290 million. The card was accepted at nine thousand establishments, according to the New York Times, from Anchorage to Tahiti. By then its merchant coverage had expanded beyond restaurants to auto rental agencies and gift shops—almost the gamut of travel and entertainment locations. Two years later, Diners Club had an annual charge volume of more than $465 million, and earned gross profits of $40 million from merchant discounts and cardholder fees.
McNamara and Schneider had not only discovered the idea of a general-purpose payment card; they had also discovered a pricing strategy that got both merchants and cardholders on board, one which has been followed by payment card systems since. By 1957, Diners Club had raised the cardholder fee to $30, but had left the merchant fee at 7 percent. It nevertheless continued to earn most of its revenues, about 70 percent, from merchants.
Diners Club faced competition soon after its entry. Information is spotty on some—National Credit Card, Inc., for instance, started its card program in 1951, operated in forty-two states, but had filed for bankruptcy by 1954. A 1955 Newsweek article referred to Trip-Charge with eighty-five thousand cardholders and nine thousand merchants after a year in business; it asserted that the founder, Sidney J. Rudolph, “is now a hairbreadth from realizing his hopeful company motto: ‘Charge Everything Everywhere.’” Esquire and Duncan Hines both had travel and entertainment cards, which merged in 1957. Gourmet magazine had a club for diners, too.
Merchant coalitions were another source of competition. Hotel owners balked at the fee they had to pay on charge cards. In 1956, the American Hotel Association established the Universal Travelcard. It didn’t charge participating hotels and rental car agencies any fee but billed cardholders the same $30 fee as Diners Club. The National Restaurant Association, with sixty thousand members, signed on. One might wonder how they could get by without the 70 percent of the pie from merchant fees that Diners Club received. Part of the answer is that they didn’t do central billing. Each hotel billed its customers directly, although the card association did ensure payment. There was a railroad card and an airline card as well.
Some banks had also entered the payment card business by the 1950s. But their cards—sometimes called “shopper” cards—targeted a different cardholder and merchant base. These bankcards were typically held by “housewives,” as the newspapers of the day put it, and could be used only at retail stores in the locality the bank did business. Franklin National Bank started one of the first shopper cards on Long Island in 1951, and one hundred or so banks—mainly small, suburban banks in the Northeast—followed. While one hundred may seem like a large number, one should keep in mind that in 1951, there were 13,455 commercial banks as well as many more credit unions and savings and loans. Banks generally charged retailers the then-standard 5 to 7 percent merchant fee. Cardholders reportedly didn’t pay any direct fees and, as with the other card programs, were supposed to pay their monthly bill in full. These cards were thus charge cards, though the press of the day called them credit cards.
Of the early major entrants, only Diners Club survived the decade as a stand-alone company. It bought Trip-Charge in 1956 and Esquire’s card program in 1958. The bankcards failed mainly because they had trouble signing up merchants, and only twenty-seven of the shopper cards were still in existence by 1957. The Universal Travelcard and the Gourmet Magazine Club card were swallowed in 1958 by a new competitor that appeared during what became a critical year for the future history of the card industry.
Diners Club also expanded overseas in the mid-1950s, using franchise agreements to extend its reach to Europe. As in the United States, European hotel trade associations posed strong resistance to the travel and entertainment (T&E) cards, going so far as to expel members who accepted payment cards that required a merchant discount. Some hotels in England and Switzerland chose to flout the prohibition; they accepted the T&E cards and formed their own association. They also went a step further: the newly formed hotel association created the BHR credit card in the 1950s, which evolved into the EuroCard in the mid-1960s.
Though planning had started years earlier, several competitors rolled out new cards in 1958. In September, Bank of America started a credit card in California. In October, American Express launched its national charge card, and Hilton Hotels spun off its hotel card into Carte Blanche.
Bank of America
California did not have restrictions on branch banking in 1958. With an economy larger than Japan’s, California was able to support several large banks. Bank of America was the largest, with over six hundred branches throughout the state. It had started as Bank of Italy in 1904, founded by one of the greats of U.S. banking, A. P. Giannini. By 1958, Bank of America was the largest bank in the United States.
Despite its size, though, Bank of America was cautious about offering a payment card, even though one of its small competitors, First National Bank of San Jose, had started a credit card in 1953. Bank of America considered introducing its own card in 1954, but initially decided that there wasn’t a good enough business case. After studying the emerging industry over the next few years, it decided to introduce a credit card in 1958. Creditworthy customers would receive cards with limits of either about $1,700, or $3,000; prior authorization would be required for purchases over about $300; and a revolving credit option was available for some cardholders. Revolving credit was the innovation that distinguished this card from existing charge cards.
The bank conducted a market test in Fresno, California, in fall 1958. Three hundred retailers signed up initially, and every Bank of America customer in the Fresno area received a card. According to one study, “This mass mailing of 60,000 cards had been William’s [the executive in charge of the effort] solution to the problem of how to convince retailers that enough individuals would possess a card to make their participation in the program worthwhile. His solution worked, for during the next five months another eight hundred Fresno-area retailers joined the newly named ‘BankAmericard’ program.” Bank of America had planned to track the financial results of the card in Fresno before going statewide, but fear of competition persuaded it to accelerate the launch. It expanded throughout the state during the following year. By the end of 1959, twenty-five thousand merchants accepted the card and almost two million California households had one.
Things did not go well at first: fraud was rampant, the number of delinquent accounts was five times higher than expected, large retailers resisted joining, and echoing an old theme, “Public criticism came from those who viewed credit as a societal evil.” The program lost $52.6 million in 1960. The bank worked on collection problems and reduced the merchant fee to as low as 3 percent to entice retailers. Delinquencies declined and the merchant base increased to thirty-five thousand in 1962. The card turned its first operating profit in 1961.
American Express
American Express started as an express mail company in 1850. Money was one of the things people wanted to move around the country, especially after the post-Civil War expansion of the rail network created national markets. Of course, people also wanted their money delivered safely. The U.S. Post Office developed the money order; American Express introduced a competing product. Both products were subject to theft, and neither was a good substitute for cash.
The travelers cheque, invented by an American Express employee and offered beginning in 1891, was a significant advance over the money order. The cheques came in multiple denominations just like cash and had the dual-signature system (sign when you obtain, and sign when you cash) that remains the major security device to this day. Initially, people could cash travelers cheques only at American Express offices; later, they could cash them directly at merchants. The major selling point for consumers was security: American Express guaranteed payment, but it also assumed responsibility for lost or forged checks. The product was a highly profitable one for American Express for over a century, although its popularity has declined steadily over the last three decades. The profits all came from individuals. A consumer purchasing $500 in travelers cheques, say, would pay American Express a fee in addition to the $500, and American Express would continue to earn interest on the amount invested in the cheques until they were cashed. Stolen or misplaced cheques that were not cashed or replaced would be pure profit.
A hundred years after its formation in Buffalo, New York, American Express was the world’s largest travel agency and operated the world’s largest private mail service. Between its cheques and travel offices, it was profiting enormously from the boom in international travel following the end of the Second World War. The number of American Express travel agencies grew from fifty at the end of the war to nearly four hundred ten years later. The company sold approximately $6.5 billion worth of travelers cheques in 1951, and by the end of the decade claimed to control 70 percent of the U.S. travelers cheque business.
The Diners Club charge card was a new competitor for American Express. By 1953, American Express had begun planning its response. It considered buying Diners Club in 1956, but rejected the idea. The company finally entered the charge card industry on October 1, 1958, with 17,500 merchant locations and 250,000 cardholders. It achieved this scale quickly by buying the Gourmet Magazine Club card and the Universal Travelcard. Within seven months of launching its card operations, American Express had over 600,000 cardholders. By late 1960, it had a charge volume of over $584 million and 750,000 cardholders.
American Express adopted a slightly different pricing policy than Diners Club. It initially set its annual fee $1 higher (in 1958 dollars) than Diners Club’s $5, thereby suggesting that it was the more “exclusive” card (in 2008 dollars, the American Express annual fee was $42 while the Diners Club fee was $35). But it set the initial merchant discount slightly lower than Diners Club’s 7 percent: 5 to 7 percent for restaurants, according to their sales volume; and 3 to 5 percent for the recalcitrant hotel industry, depending on the hotel guest’s charge level.
American Express struggled at first. Even a charge card involves extending credit for a time, and American Express, unlike the founders of Diners Club who have been in the consumer credit business, had no experience doing this. By 1961, with losses mounting, it considered selling the business to Diners Club, but decided that such a sale might not pass muster with the Justice Department. Instead, American Express hired George Waters, later known as the “Father of the Card,” to run its card operations. Waters started putting pressure on customers who had not sent their payments in on time. And he raised the annual fee to $46, and later to $56. Despite the increased fees, the American Express payment card system continued to grow. By the end of 1962, there were 900,000 American Express cardholders who could use their cards at 82,000 merchant locations. In 1962, almost four years after its launch, the card operation posted its first (small) profit.
Today, American Express accounts for 13 percent of the dollars transacted on payment cards. By that measure, it is almost a quarter of the size of the Visa system (see Table 1.1 in chapter 1) and almost one-half the size of MasterCard. Diners Club, on the other hand, shrunk to almost nothing within the United States. The charge card pioneer spread itself too thin in the 1960s and early 1970s in an attempt to counter the inroads made by American Express. In particular, Diners Club tried unsuccessfully to follow the American Express model by expanding into travel clubs and travel agencies, but it lost money on both endeavors and lost sight of the newly emerging competition from the bankcards.
Carte Blanche
Hilton Hotels had issued a million charge cards for use at its worldwide hotel chain. After a failed attempt to buy Diners Club, it rolled its hotel card into a new general-purpose card company, the Hilton Credit Corporation, which distributed the Carte Blanche card. In 1958, it entered with a low merchant fee, 4.5 percent, which soon dropped to 4 percent. The 600,000-member National Restaurant Association, which had been complaining about the 7 percent fees charged by Diners Club and American Express, threw its official support behind the card. Nonetheless, as a result of issuing cards to the wrong people and an inefficient billing system, Carte Blanche became known in the trade as “Carte Rouge” for its steady losses.
What Happened to the Class of 1958
In 1960, a decade after the birth of the general-purpose payment card, there were three major national card systems. Diners Club, with 1.1 million cardholders, was still the biggest, but it faced competition from recent entrants American Express and Carte Blanche. These three, in turn, faced regional competition from BankAmericard in California and Chase Manhattan in New York City, though nothing else of significance. Chase Manhattan sold its card program to a subsidiary of American Express in 1962. This became the Uni-Card—a credit card that was available in the Northeast United States. It was sold back to Chase in 1969. Chase joined the BankAmericard association in 1972 and converted its cards to the BankAmericard brand.
Carte Blanche was sold to Citigroup in 1965. (Citigroup started as First National City Bank.) Pressured by an antitrust suit brought by the Justice Department, Citigroup sold Carte Blanche in 1968. The Justice Department was concerned that with Carte Blanche, Citigroup might limit development of the “Everything” credit card program it had started in 1967. When Citigroup quickly dropped the Everything card and had not introduced a replacement by 1978, however, the Justice Department relented, and Citigroup bought Carte Blanche back again. By that time, Carte Blanche’s share of credit card volume had declined to less than 1 percent.
American Express moved past Diners Club to become the industry’s volume leader in 1966. Diners Club continued to decline throughout the 1960s, in part because it lacked the travel offices that American Express used to distribute its card during the industry’s early days. American Express also had a better T&E brand as a result of its travel offices and travelers cheques. Diners Club attempted to meet American Express head-on through travel and reservation system acquisitions, but it failed to make those profitable. Diners Club was sold to Citigroup in 1981. After the sale, Diners Club shifted its focus to affluent business travelers, trying to follow American Express’s successful up-market strategy. The final indignity for this pioneer came in 2008 when Discover, the newest and smallest of the payment networks, bought Diners Club International for $165 million (Citigroup retained the franchise to issue Diners Club cards in the US but then sold even that to Bank of Montreal in 2009.)
And the statewide BankAmericard became the worldwide Visa card.
Another watershed year for the emerging payment card industry was 1966, which marked the start of a battle between three competing business models for operating payment cards.
Figure 3.3: Bank Associations Entry in 1966
American Express, Carte Blanche, and Diners Club were mainly used for travel and entertainment, and thus became known as T&E cards. They did not offer credit beyond the time it took to get cardholders their monthly bills, which had to be paid in full. Nor was there a link to cardholders’ checking accounts. Many business travelers and wealthy households had one of these cards, but most Americans didn’t. Data for 1966 are not available, but even by 1970 only 9.2 percent of households had one of the T&E cards.
Interstate banking regulations and other hurdles made it difficult for Bank of America to compete head-to-head with the three T&E cards. To take its card national, the California bank decided to franchise. In 1966, it announced that it would license its BankAmericard program to selected banks across the country. Each bank would operate the program independently using the BankAmericard name; merchants signed up by the franchisees would have to accept all BankAmericards, allowing consumers to use their BankAmericards at any participating merchant. Bank of America charged the franchisees a royalty of up to 0.5 percent of cardholder volume and an entry fee of about $132,000.
Unlike T&E cards, bankcards did not charge cardholders membership fees, earning revenue from finance charges and merchant discounts instead. For example, the Chase Manhattan Charge Plan, introduced in 1958, charged cardholders 1 percent of the revolved (that is, unpaid) balance every month, while charging merchants 2 to 6 percent of sales depending on volume.
The BankAmericard franchise was not limited to the United States. Major banks in countries such as Canada, Columbia, Italy, Japan, Mexico, Portugal, Spain, the United Kingdom, and Venezuela signed up as international BankAmericard franchisees around the same time as the domestic franchise system launch in 1966. In 1968, MasterCard also expanded internationally by forming alliances with EuroCard, the European card association mentioned earlier, and Banco Nacional in Mexico. The alliances allowed the MasterCard network and foreign networks to interoperate, but preserved each card as a distinct brand. In addition, MasterCard expanded in Asia by gaining member banks in Japan.
In the United States, within two months of the Bank of America franchising announcement, American Express, Carte Blanche, and Diners Club responded by offering their own franchise opportunities to banks. The American Express bankcard differed from the standard card: it offered a minimum $9,000 line of credit. American Express would split revenues with the banks: banks got a commission for signing up cardholders and revenues from credit provided by the card; and existing American Express cardholders could be converted to the bank program. American Express didn’t charge additional franchise or licensing fees. Carte Blanche priced its franchise at $45 for every $5.3 million in bank assets, with a $26,429 minimum fee. Diners Club offered to franchise its card for that same fee to banks with less than $5.3 billion of assets and for $52,858 for banks with $5.3 billion or more. While the historical evidence is sketchy, it does not appear that the various efforts at franchising these cards attracted any takers within the United States. (American Express also planned to franchise its Uni-Card credit card across the country in 1968. It had a million cardholders and eighteen thousand merchants in New England, New York, New Jersey, and Pennsylvania. Instead of following through on those plans, though, it sold the Uni-Card program back to its original owner, Chase Manhattan, in 1969, and Chase converted these cards to BankAmericards in 1972.)
For many banks, there were significant negatives to the franchise system. Major banks, including Wells Fargo in California and Chase Manhattan in New York, were not eager to sign up to issue someone else’s card. The successful franchise systems we’re familiar with—McDonald’s, the Athlete’s Foot, or Mail Boxes Etc.—typically involve a prominent brand name with outlets operated by unknown local entrepreneurs. Although some franchisees can become quite successful with multiple locations, they generally have little ability or desire to promote their brand name over the franchisor’s. This was not the case with the major banks.
Developing a proprietary card system was another option for banks. As we mentioned, Citigroup, in addition to owning Carte Blanche, had started its proprietary Everything card in 1967. Because Citigroup held a national banking charter and had customers across the country who were potential payment cardholders, it initially hoped to develop the Everything card into a national brand. Other banks found this option unattractive. While a national charter was, legally speaking, not necessary to issue credit cards around the country, some banks were reluctant to expand out-of-state.
Many banks found the answer in co-opetition. Banks competed for merchants and cardholders; banks cooperated at the card system level by setting operational standards. Despite the dismal experience of the 1950s, many banks decided to start cards in the 1960s. They compared the problems of going it alone to the benefits of cooperation. The calculus led them to form associations. Five banks in Illinois founded the Midwest Bank Card. By January 1967, nearly six hundred banks in Illinois, Indiana, and Michigan had joined; some of these issued one of the five original members’ cards. There were also two Michigan associations. Other banks across the country followed. Three New York City banks started the Eastern States Bankcard Association in June 1967. The state and local banking groups began to develop ties with other groups. The Interbank Card Association started in 1966. Early on it included banks in Buffalo, Pittsburgh, Milwaukee, Seattle, and Phoenix. At the same time, several banks in California started the Western States Bankcard Association, issuing cards under the Master Charge service mark. By 1967, the California banks issuing Master Charge had joined the Interbank Association. By February 1968, Interbank had 286 banks in at least seven states.
It became apparent during 1968 that two competing national networks of banks had emerged: the BankAmericard franchise system, and the Interbank cooperative system. Banks—and groups of banks—started aligning with one or the other. “Just about every bank in the card field,” said Business Week, “is convinced that it must join one or the other network.” Bankers Trust in New York City went with BankAmericard and franchised the card to other banks in the New York area. Meanwhile, Citigroup converted its Everything card to Master Charge and joined Interbank. Chemical and Manufacturers Hanover joined that association as well. For the most part, the larger banks had chosen Interbank over BankAmericard. In contrast to the BankAmericard franchise model, Interbank charged only a “modest” entrance fee and a small annual fee to cover the operating costs of the joint enterprise. And as noted, banks would be selling a brand they jointly owned, rather than that of another bank. This was an important point for banks that harbored hopes of future national expansion when interstate banking restrictions were lifted—though in hindsight, that was still more than three decades away.
BankAmericard was not doing too badly by many measures. Under its franchise model, it had about 27 million cardholders and about 565,000 merchants by 1970, a sizable jump from 1.8 million cardholders and 61,000 merchants in 1966. But it was in the process of being overtaken by Interbank, which had attracted most major banks. And the franchisees were restless.
The franchisees quickly went from restless to rebellious. They had grown in importance to the system and wanted a voice in its future. In 1970, faced with this revolt as well as with operational problems, Bank of America agreed to convert the system into a membership-owned corporation: National BankAmericard, Inc. (NBI). NBI wasn’t an ordinary stock corporation; instead, its members had voting rights that couldn’t be bought or sold. Initially, NBI had 243 charter members, including Bank of America, Bankers Trust, and First Chicago as well as numerous smaller community and regional banks.
The brief period 1966-1970 turned out to be critical for the future development of the payment card industry. Three alternative business models battled against each other. The go-it-alone model had been the one used by American Express, Diners Club, and Carte Blanche for charge cards. Bank of America adopted this model in California, Citigroup tried it with its Everything credit card, and American Express tried it with its Uni-Card credit card. Bank of America and the three T&E card companies tried the franchise model. Finally, the co-opetitive model was used by Interbank and many other associations of banks across the country. The web of interstate and branch banking restrictions played a crucial role in the battle among these models.
By the end of the 1960s, the franchise model was dead in the United States. And the go-it-alone companies and the co-opetitives had gone in different directions. Sticking to what they knew best, the go-it-alones decided not to issue credit cards. American Express had ventured into credit with its Uni-Card, but decided to get out and did not try again for twenty years. The co-opetitives, on the other hand, focused on issuing cards with a revolving line of credit. (Debit cards were soon added, but took until the mid 1990s to have an impact.)
The basic idea behind co-opetition was clear as early as the Midwest Bank Card. The five founding members competed with each other for cardholders and merchants in the Chicago area. They cooperated in two related respects. They agreed to make their systems “interoperable.” A First National Bank of Chicago cardholder could use her card at every merchant who had signed up with any of the five banks. A Harris Trust Company merchant could accept as payment any card from these banks. What the banks lost in helping their competitors, they more than gained in making their own card more appealing to cardholders and merchants. Interoperability forced cooperation in another way. When a First National Bank of Chicago cardholder bought something at a merchant who was affiliated with Harris Trust Company, Harris Trust had to get reimbursed by First National. These banks faced the same problem as in the BankAmericard franchise: system cooperation was essential to process the slips of merchant receipts that were growing exponentially with the number of participants in the system.
The two national associations encountered similar issues to Midwest Bank Card, only on a grander scale. MasterCard—which started out as the Interbank Card Association in 1966, changed its acceptance brand to Master Charge in 1969, and finally became known as MasterCard in 1979—and Visa—which began as BankAmericard in 1958, switched to National BankAmericard, Inc. in 1970, and settled on Visa in 1976—took cooperation further than any of the regional associations. First, they established rules and processes for settling transactions. Part of this involved how the merchant and the cardholder banks divvied up the transaction proceeds. Some of the regional cooperatives had initially exchanged at par so that the cardholder’s bank reimbursed the merchant’s bank for the entire transaction and the cardholder’s bank didn’t get any of the merchant fees. (The banks may have simply been applying the check model of par exchange, which they soon found unsatisfactory for cards.) MasterCard and Visa both settled on an interchange fee—a percentage of each transaction that the merchant’s bank gave to the cardholder’s bank.
Another area of cooperation was on the card brand. The banks that belonged to Interbank decided early on to use the Master Charge brand. That—and not the individual bank’s name—was most prominent on the cards from the late 1960s and early 1970s. Visa replaced BankAmericard as the brand name for that system in 1976. The co-opetitive felt that “standardizing the somewhat confusing array of blue-white-and-gold cards issued under different names in twenty-two countries around the world” would lead to greater acceptance of the card. Focusing on the system’s brand involved a trade-off basic to the co-opetitive model: choosing between doing things at the system versus the member level. Overall, the co-opetitives chose to do most things at the member level.
In a few pages we will tell the story of how the bank associations died. Yet they endured for about four decades and were responsible for the remarkable growth of the payment card industry and for shaping the industry we know today.
American Express prospered during the 1970s. Between 1960 and 1977, real net income grew at an average annual rate of 16.6 percent. By 1977, American Express had eight million cardholders, bringing in $459 million in annual card fees. Its lead over Diners Club and Carte Blanche had widened dramatically. American Express had decided against offering a credit card and had unloaded its Uni-Card credit card. About 200,000 of its cardholders had “corporate cards”-cards that employers ask employees to use for expenses and that provide employers with detailed spending data. Sticking with charge cards, shunning credit cards, and focusing on corporate users was a profitable strategy for some time.
Table 3.1
U.S. recessions, 1969-1982
Note: The National Bureau of Economic Research defines a recession as “a period of significant decline in total output, income, employment, and trade.”
Sources: National Bureau of Economic Research, U.S. Business Cycle Expansions and Contractions, (accessed April 21, 2003); and U.S. Department of Labor, Bureau of Labor Statistics.
Meanwhile, American Express’s credit card competitors—the banks that issued credit cards and the two associations to which they belonged—struggled during this decade of government regulation, volatile interest rates, and economic stagnation. The economy went through several severe recessions in the 1970s and early 1980s (see Table 3.1). The economy also experienced accelerating inflation, jumping from 4.2 percent in 1972 to a peak of 9.4 percent in 1981. This led to an increase in (nominal) interest rates. (Economists distinguish between nominal interest rates, which are quoted by lenders, and real interest rates, which are lower than nominal rates by the rate of inflation. Real rates adjust for the impact of inflation on purchasing power over time; nominal rates tend to vary with the rate of inflation, all else being equal.) The one-year Treasury bill rate climbed from 4.9 percent in 1971 to 14.8 percent in 1981. As interest rates climbed, state usury laws made credit card lending a bad business proposition. Banks need a spread between the finance rate they charge consumers and their own cost of funds to cover their operational costs, including fraud and defaults, and make a profit. As inflation rose, that spread generally narrowed and even became negative in states with low caps on loan rates. Banks lost money on the credit they had already made available on cards and became unwilling to extend further credit in the face of these losses. Usury laws, and a Supreme Court decision about them, helped shape the card industry in the 1970s and beyond.
Thirty-six states had usury laws in 1982. Some had caps that were so high they didn’t matter during times of normal inflation and interest rates—for instance, Georgia had a maximum of 60 percent. But others topped out at rates that made it difficult for banks, even in not too far from normal times, to make unsecured loans profitably. Arkansas, for example, had a maximum rate of 5 percent above the Federal Reserve discount rate, giving a maximum rate of about 12 percent at the time. Banks lived with their state caps by tailoring their credit card lending. Banks in states with high limits could extend credit to a wide range of people because they were able to charge finance rates that covered the inevitable defaults, late payments, and fraud. Banks in states with low limits raised their credit criteria for issuing cards and imposed higher membership fees. For example, because Arkansas imposed a low cap on consumer loan rates, banks in that state had to set their standards relatively high and offer credit to very few people in order to hold down costs. As a result, charge-off rates in Arkansas were low, but so was the use of credit cards. (Charge-offs are credit card balances that have been written off as losses for tax purposes.)
Usury laws had a significant effect on the development of a national card industry because they limited the ability of banks to market their cards on a national or even regional basis. Interest rates that were lawful in one state were unlawful in another. A bank therefore couldn’t market a card nationally or regionally and capture scale economies from wide distribution. The few banks that issued in multiple states had to incur the expense of administering multiple card programs with different terms in each state. This wasn’t just an issue of processing extra paper; the banks had to adjust credit standards and collection criteria according to the finance charges they could assess in each state.
A Supreme Court decision changed the rules of the game in 1978 and helped create national competition for payment cards. First of Omaha Service Corporation, a subsidiary of First National Bank of Omaha, began to apply interest rates that were legal in Nebraska, but higher than the Minnesota rate ceiling, to its Minnesota credit card customers. Marquette National Bank of Minnesota challenged this practice. The Supreme Court sided with First of Omaha. In Marquette National Bank v. First of Omaha Service Corp., the Court ruled that as a national bank, First National Bank of Omaha “may charge interest on any loan at the rate allowed by the laws of the State where the bank is located.” The Court also said that a bank’s “location” refers to the state in which the bank is chartered, regardless of the states in which it solicits customers.
The Marquette decision led to three major developments. First, nationally chartered banks started issuing credit cards from states with less-restrictive usury laws. Citigroup, for example, moved its credit card operations from New York, which at the time had an interest rate cap of 12 percent on balances greater than about $1000, to South Dakota, which had raised its interest rate ceiling to 19.8 percent. Many other banks moved their operations to Delaware, which eliminated interest rate caps in early 1981. By 1987, many large banks legally resided in Delaware, including Bankers Trust, Chase Manhattan, Chemical, Manufacturers Hanover, Morgan, and Marine Midland.
Second, in an attempt to attract or retain such movable card operations, some states began to modify their usury laws. In 1980, the same year that Citigroup announced it would be moving its operations to South Dakota, the New York State Senate passed a bill that eliminated interest rate ceilings on most types of loans, except annual rates on credit cards, which remained at 25 percent. By 1988, the majority of states still had some form of an interest rate cap on credit card loans, but many had raised their ceilings.
Third, less balkanization from state credit restraints set the stage for marketing payment cards on a nationwide basis. Citigroup led the way in the late 1970s and early 1980s: it expanded nationwide through acquisitions and mass-mail credit card solicitations. Throughout the 1980s, many other banks launched national credit card campaigns as well, including Bank of America, Chase, Continental Illinois, First Chicago, and Manufacturers Hanover. By permitting nationwide competition, Marquette enabled issuers to realize scale economies in marketing and processing costs, thereby making payment cards more readily available to consumers across the country. Thus, even though Arkansas still caps interest rates at 5 percent above the Federal Reserve discount rate today, consumers in Arkansas have a wide range of card choices from national issuers.
Federal antitrust laws also had a major effect on the evolution of the payment card industry in the 1970s. Visa’s rules initially prohibited MasterCard-issuing banks from issuing its cards or handling its merchant paper. In July 1971, one of Visa’s charter members, Worthen Bank and Trust Company of Little Rock, Arkansas, filed an antitrust suit, claiming that Visa’s prohibition amounted to an illegal group boycott. While this case was eventually settled out of court, Visa remained exposed to similar lawsuits. In 1974, it asked the Antitrust Division of the U.S. Department of Justice for a business clearance review—in effect, a letter of approval for a rule that would prohibit dual membership by card-issuing and merchant-acquiring banks. After a year of consideration, the division declined to grant clearance, citing insufficient information. Without the division’s support, Visa removed all restrictions on dual membership in mid-1976. The age of what has become known as “duality” began, and members of each system rushed to join the other.
Competition among issuers increased sharply as new members scrambled to sign up consumers for their second card. From mid-1976 to mid-1977, the number of cardholders increased by 11.7 percent for MasterCard and 13.1 percent for Visa—significantly higher growth than in preceding years. Banks that were previously exclusive to MasterCard could now sign up their merchants for Visa (and vice versa) as well as compete generally for merchants. Merchant acceptance grew sharply from mid-1976 to mid-1977, by 24.3 percent for MasterCard and 17.3 percent for Visa, again much higher than in preceding years.
One year after the restriction was removed, twenty of the nation’s twenty-two-largest banks that issued cards had become dual. With increased system overlap, Visa and MasterCard twice discussed the possibility of merging system infrastructures in the 1980s, but decided against the move both times. With duality, the difference between Visa and MasterCard began to blur, at least as far as consumers were concerned. Some dual members offered common agreements, billing statements, and credit lines. Some used common advertisements for their dual cards.
Over time, almost all member institutions joined both associations, and the increasing overlap in membership led to some decline in competition between the two systems. Dual membership lost some of its appeal in the late 1990s. The Justice Department, ironically, claimed in a case filed in 1998 that MasterCard and Visa were violating the antitrust laws by having dual membership. A federal district court judge disagreed. By then, though, meaningful duality had withered, as the associations sough allegiance, and in the next decade the associations were disbanded.
The Visa and MasterCard associations had little trouble finding banks to join their still-fledgling associations in the 1970s. First, banks were afraid of being left behind. Many banks got into the card business to preempt or counter their competitors’ plans. Second, there was a growing belief that credit cards were a stepping-stone to the “cashless society.” Third, cards created an opportunity for cross selling. Many banks even felt that they could not offer their retail customers an acceptable menu of banking services unless they operated a card plan. And fourth, even though achieving profitability would remain challenging, some banks had shown they could make money in the card business. The number of bank issuers grew from about 600 in 1971 to at least 1,750 in 1981.
The association model provided banks with opportunities to specialize that they didn’t have with their earlier go-it-alone card programs. Banks could just issue cards, since those cards could be used at all merchants that were card customers of other members of the association. Or they could just handle credit card transactions for merchants (as acquirers). They could also do both—which is what most banks did in the 1970.
Nonetheless, echoing some of the problems of the 1950s, profits did not come easily or quickly. The early 1970s were marked by substantial losses. As described in 1971 by the American Banker: “The top managements of many of the nation’s large credit card issuing banks, though, are becoming increasingly disillusioned with the negative profit contribution of their card programs and are questioning whether they can afford to stay in the business.” Wells Fargo lost more than $31 million between 1967 and 1970; Bankers Trust lost nearly $27 million in 1969 and almost $13 million in 1970; Riggs National Bank lost almost $5 million in 1970 (as always, these figures are in 2008 dollars). All told, bank credit card losses in 1970 rose 50 percent over 1969, to $514 million or 3.4 percent of the outstanding credit card debt.
There were a couple of reasons for the mounting losses. First, and perhaps most important, the credit card business was quite different from traditional types of lending. As one industry observer noted, banks entered the credit card industry “without being remotely prepared to solve the hundreds of problems, both large and small, that were bound to arise.” Learning what worked and what didn’t involved costly mistakes and inefficient practices. Second, banks did not have the luxury of starting out small while learning the business. As the American Banker reported in 1966: “Credit cards are not something a bank can ‘feel its way into.’ They require a big splash of publicity, much careful planning, aggressive selling and perhaps above all, the courage to continue as the losses mount.”
The second reason behind the mounting losses of the early 1970s had its roots in the late 1960s. The “big splash of publicity” that banks used to enter the payment card industry often came in the guise of mass mailings of free, unsolicited credit cards. Banks typically drew names for the mailings from lists of depositors and customers with mortgage and installment loans. The mass mailings got the cards to lots of consumers, providing a sufficient cardholder base to attract merchants. But they also came at a price. Given the volume of consumers who received a free card in the mail and the rush to beat competitors’ card offerings, the banks often did little more than a basic credit check, and some didn’t even do that much. Moreover, they could not provide secure delivery of cards. Chicago postal clerks were caught hoarding unmailed cards to sell on the black market; small-time criminals stole cards out of mailboxes; even the Mafia got involved, trafficking in stolen cards and working with dishonest merchants to submit false sales slips. As a result of all this, the levels of fraud and defaults in the early 1970s were quite high. (In April 1970, the Federal Trade Commission banned the mass mailing of credit cards.) The economics of two-sided markets tells us that we should not be too quick to claim that these efforts were bad business, however. Many platforms invest in getting one or both sides on board; it is unclear whether banks could have ignited their platforms in some other way without incurring comparable losses.
Added to the turmoil of fraud and consumer delinquency were the thorny issues of how to coordinate the various banks in the system. Who was responsible for fraud and unpaid cardholder bills, and how would the various parties settle with one another? Recall that in the early 1970s, the newly formed bank associations did not have computer systems to smooth transactions; everything was done with paper and postage.
Although bankcard issuers had started to leave the red ink behind by 1972, they still found it difficult to earn the same returns from credit card lending as they did in their other lines of lending. From 1974 (the earliest year with available data) through 1980, the rate of return on assets (net before-tax earnings divided by assets) on credit card lending ranged from 1.61 percent (in 1980) to 3.09 percent (in 1977), for an average of 1.53 percent. In contrast, banks earned far higher average rates of return on other forms of lending over that same period: 2.26 percent on installment loans, 2.48 percent on real estate loans, and 3.04 percent on commercial loans. The discrepancies are especially surprising given that credit card loans are not secured with physical assets, whereas the other loan types are. Credit card loans were thus riskier to make, but earned banks a lower return throughout the 1970s.
Although the bankcard programs struggled in the 1970s, the associations to which they belonged laid the foundations for the modern electronic payment card systems. The associations established their brands—MasterCard and Visa—firmly in the minds of households and merchants. Both associations spent millions of dollars in the 1970s on national television ad campaigns, such as the 1973 “Relax—you’ve got a Master Charge” effort. Most important, they relied on the computer revolution to develop systems for quickly and efficiently authorizing as well as settling transactions among the growing numbers of merchants, cardholders, and members.
Visa built the BASE-I system using computers from Digital Equipment Corporation. The system allowed a merchant’s authorization request to be transmitted over phone lines from the merchant to the cardholder’s bank, with Visa providing backup when the cardholder’s bank was closed. This went online in 1973. BASE-I cut the wait for a transaction authorization from four minutes on average to about forty seconds. It cost about $35 million to build, but it was estimated to have saved members over $110 million in fraud prevention in its first year of operation. Visa then set about building BASE-II, which computerized the entire transaction process and solved the other major member headache: the physical interchange of paper among members. BASE-II went online in 1974. MasterCard made similar investments to move its systems off paper and onto computers, with its own BankNet and I-Net systems.
Let us take stock of the shape of the payment card industry in 1983—a year that marked the end of stagflation in the United States and the start of a long economic expansion. At least 1,500 companies ran credit or charge card programs in the United States. All of the companies with credit card programs were financial institutions that belonged to the MasterCard and/or Visa associations. Many issued cards with both brands; those that acquired transactions from merchants did so for cards from both associations. American Express was the major charge card company with 87 percent of all T&E cards; Carte Blanche and Diners Club, both operated by Citigroup, held the remainder. Table 3.2 lists the top issuers in 1983 of credit and charge cards by gross charge volume.
Table 3.2: Top issuers of credit and charge cards, 1983
Note: Numbers may not add up to totals due to rounding. Sources: The Nilson Report; Visa U.S.A.
The payment card industry was poised for growth. Interest rate ceilings were no longer as serious a problem. Banks’ cost of funds fell dramatically after the 1980-1982 recession, and usury laws were less prevalent, less severe, and after the Marquette decision, less important. Many banks had mature card programs with customers whose credit behavior they had observed for some time. The 1970 Fair Credit Reporting Act helped to ensure that creditors had access to accurate credit reports, increasingly at the national level. And the card industry had learned from experience how to reduce losses from cardholders who didn’t pay their bills.
Credit cards were well-understood products that could make money for banks in several ways. Banks that issued cards charged membership fees. (Many banks had instituted these fees in response to a 1980 Federal Reserve requirement that they hold reserves against outstanding credit card debt.) They also earned income from merchants: they received a percentage of each transaction through the interchange fee, which was around 1.6 percent in the early 1980s. And they received finance charges from cardholders who revolved their balances. Banks that acquired transactions from merchants earned revenue from fees that were usually based on percentages of transactions volume.
The payment card industry grew dramatically over the remainder of the 1980s, during one of the longest peacetime economic expansions in U.S. history. Between 1982 and 1990, overall consumer spending rose from $4.0 trillion (about $48,000 per household) to $5.6 trillion (almost $60,000 per household). Retail spending increased from $2.1 trillion (about $25,000 per household) in 1982 to $2.7 trillion (around $29,000 per household) in 1990. Restaurant spending almost doubled from $140 billion ($1,700 per household) to $262 billion ($2,800 per household). These increases naturally provided more opportunities to use payment cards. Dollar transactions on credit and charge cards increased from $181 billion in 1982 to $467 billion in 1990. Part of this increase reflected growth in spending on cards by people who had cards. The average monthly charge on cards increased from $313 per household in 1977 to $461 in 1992. (Data are not available from the early 1980s.) Another part reflected growth in the number of households with cards. The percentage of households with at least one card increased from 43 percent in 1983 to 62 percent in 1992. (More people started carrying multiple cards so the average amount charged per card did not increase as much as the average amount charged per household.)
People not only charged more. They borrowed more. Between 1982 and 1990, the total amount of consumer credit outstanding rose from $747 billion to $1,186 billion, and the average consumer credit outstanding per household increased from almost $9,000 to just under $13,000. Thus, the total consumer credit outstanding grew at an average annual rate of 6 percent. Credit card debt grew even faster: outstanding loans on credit cards grew at an average annual rate of 21 percent, from about $58 billion to $263 billion, increasing from about $680 to slightly more than $2,800 per household in 1982 and 1990, respectively
Not surprisingly, the increased demand for payment and credit services, combined with a more favorable financial environment for payment card issuers, generated an enormous increase in the supply of payment card services. Existing issuers from Citigroup to American Express issued more cards. More important, banks that wanted to get into the card business could issue the established MasterCard and Visa brands, and consumers could use the cards they issued instantly at the millions of merchants who already took these two brands. Between 1981 and 1991, about 4,200 financial institutions became issuing members of the Visa association. (The pool of possible entrants expanded as a result of 1982 legislation that made more institutions eligible for federal deposit insurance.) Several of these entrants are particularly noteworthy, and we will discuss them shortly.
On the other side of card transactions, acquirers signed up more merchants during the 1980s—both new merchants who were part of the wave of new business formation and existing merchants who hadn’t taken cards before. From 1982 to 1990, the number of U.S. merchants accepting Visa increased by 37 percent. By 1991, more than 2.5 million merchants accepted Visa cards. MasterCard experienced a similar growth in merchant acceptance.
The increased supply of card services for customers and merchants came from three other notable sources. Sears, Roebuck and Co. started the Discover Card in 1985 (and went national in 1986). Less than two years after the signature orange-and-black Discover Card was released, there were twenty-two million cards in circulation—more than Citigroup had accomplished after two decades—and $4.7 billion in receivables, ranking it third among all credit and charge cards in the United States. Over 700,000 merchants accepted the card by 1987.
Less than two years after the Discover Card launch and about twenty years after selling its credit card (the Uni-Card), American Express launched the Optima credit card. Yet what American Express thought would be a successful competitor to the bankcard issuers quickly turned into a disaster. Default rates skyrocketed and losses soared, costing the company hundreds of millions of dollars. This sophisticated company’s problems make clear the complexity of the credit card business. American Express assumed that their charge card holders would be good credit risks—after all, they paid their bills on time. What American Express failed to recognize, though, was that many of these charge card holders were using their cards for company business for which they were reimbursed. They were less conscientious when they had to pay the bills themselves. There were enough defaults to sink the Optima card in red ink. By October 1991, during a recession that hit white-collar workers particularly hard, about 8 percent of Optima’s receivables were charged off. The credit arm of American Express had to take a $382 million charge against third-quarter earnings in 1991, including $158 million to restructure the credit card operations and $223 million to add to credit loss reserves. In addition, about 1,700 employees were laid off. Altogether, American Express reported a 93 percent drop in its third-quarter income for 1991. By early 1992, Optima’s credit losses topped out at 12 percent of receivables. American Express eventually turned its credit cards into a success in the 1990s, as we will see, but it wasn’t easy.
Meanwhile, the pioneers of the payment card industry, Diners Club and Carte Blanche, had become marginal players in the United States by the end of the 1980s. Together, they had a share of less than 2.5 percent of payment card transaction volume.
In the 1980s, several significant entrants into the card business came in through MasterCard and Visa. Three giant nonfinancial firms—AT&T, General Electric, and General Motors—decided to get into the card business. MasterCard was much more enthusiastic about these nonbanks becoming part of its association than Visa was, so many of these firms issued MasterCards at first. These firms either bought banks that were members of MasterCard or Visa, or they entered into contracts with banks that were association members. Either way, it was the industrial giants whose names were prominently featured on the cards.
Many of the nonbanks’ cards were tied to the business of the firm that sponsored the card. “We saw our relationships with twenty-two million calling-card customers in jeopardy,” stated Paul Kahn, head of AT&T Universal Card Services Corp. Thus, AT&T linked its card to its primary business; the payment card could function as a calling card. A General Motors card allowed cardholders to accumulate points that could earn a rebate on a General Motors car. General Electric’s card, however, had no such links. Instead, it offered general reward coupons that were redeemable at various retailers. The nonbank firms gained many cardholders and became some of the largest programs in the early 1990s. In fact, two of the top ten bankcard issuers in the early 1990s (by charge volume from 1991 to 1994) were nonbanks: AT&T Universal and Household Bank (which issued a General Motors card).
Some, but not all, of the nonbank card issuers were able to sustain this early growth. Still, the General Motors card is issued by Household (owned by HSBC) and enables cardholders to accumulate points toward a General Motors car. In 2009, General Electric Capital Financial was the twelfth-largest issuer, by charge volume, of general purpose cards; it issued cards for all four networks. AT&T, in contrast, sold its card portfolio to Citigroup in 1998, though the AT&T Universal card continues to function as an AT&T calling card.
Two other kinds of cards were introduced in the 1980s that were notable marketing successes. The first was proposed by one of the bank associations. In 1978, Visa introduced affinity programs that for the first time, allowed a nonmember’s name or logo to be displayed on the face of the card. In 1980, however, Visa banned new affinity card programs, arguing that they tended to dilute the Visa brand, but it allowed the existing programs to continue. Five years later, faced with apparent payment card saturation, both Visa and MasterCard began allowing new affinity programs. After only one year, 296 clubs, charities, professional associations, and other nonfinancial organizations had developed Visa and MasterCard affinity programs. By 1989, there were over 2,000 affinity card programs in the United States, ranging from the Sierra Club to the National Football League to the UCLA Alumni Association. Affinity cards involving for-profit companies are also known as “cobranded” cards.
The other new type of card was introduced by Citigroup. Citigroup and American Airlines announced the AAdvantage bankcard in April 1987, marketing it to about six million members of American’s AAdvantage frequent-flier program. At the time, AAdvantage was the largest-frequent flier program, and Citigroup was the largest credit card issuer in the United States with fifteen million cards issued. The card had a $58 annual fee and credit lines of up to around $58,000, which led some industry expert to assume that Citigroup was “competing for the same kinds of customers as American Express Co.’s Green and Gold Cards.” By early 1993, about 1.5 million AAdvantage credit cards were in circulation. These three payment card innovations in the 1980s—the nonbank issuers, affinity and cobranded cards, and frequent-flier rewards cards—each contributed to a dramatic rise in consumer card use over the decade. By 1991, there were almost twice as many cards per household compared to five years earlier.
In 1990, almost 65 percent of payment cards in the United States offered revolving credit. And most households used credit cards for consumer purchases. Charge cards were used mainly for business expenses. Although ATM cards were common—accounting for about 31 percent of payment cards—and were technically debit cards (usable at those few merchants equipped to accept PIN debit), consumers hardly ever made purchases with them.
This mix of cards was quite different from that in other industrialized countries. Banks in most European countries, for instance, issued debit cards more often than credit cards. Some of these cards were deferred debit cards: the charges were accumulated and then deducted from the cardholder’s checking account at the end of a monthly billing cycle. Others deducted charges right away. Credit cards were much less common. For example, virtually all cards in France and 83 percent of all cards in Germany were debit cards. In Japan, credit cards resemble Europe’s deferred debit cards: consumers agree to pay the card balance at the end of the month, and issuers are authorized to directly debit a customer’s account to pay the total outstanding shortly after the last day of the payment cycle.
Debit cards had been around in the United States since 1975, but they were rarely used. That changed in the 1990s as a result of two developments. After several false starts, the Visa association found a way to ignite debit cards—to get its members to issue them and households to use them. Since most of these debit cards required the cardholder to sign an authorization slip, we call them signature debit cards here. The other development came from outside the traditional payment card industry. The Electronic Fund Transfer (EFT) networks, which at the time were operated mainly as associations of banks, transformed ATM cards into debit cards during the 1990s by persuading merchants to install equipment to accept them. Since these cards required cardholders to enter their PIN, we refer to them as PIN debit cards.
The contracts that merchants entered into with Visa acquirers required them to take all Visa cards—debit cards as well as credit cards. From the standpoint of the merchant, Visa’s debit cards worked just like its credit cards and didn’t require any additional equipment or training. But Visa didn’t have the other side of the market—the cardholders—because banks hadn’t been interested in issuing these kinds of cards. As we describe in more detail in chapter 8, Visa embarked on a campaign to convince banks that they could make money from debit cards and to convince cardholders to use these cards. Visa made a commitment to promote a new debit card brand—Visa Check—through extensive national advertising. Around the same time, Visa staff tried to convince banks that the interchange fee revenues they would receive from transactions on the cards they issued would make these cards profitable. (Visa’s debit card interchange fees were set slightly lower than its credit card interchange fees at the time.) MasterCard followed with a similar product and strategy after initially pursuing an unsuccessful PIN debit strategy.
The bank that operated the EFT networks faced a different business problem: they had gotten many cards into the hands of households, but didn’t have merchants who were willing to take those cards. During the 1980s, banks had installed ATMs and issued cards to their customers that allowed them to take out cash and conduct other banking transactions. Associations of banks formed that enabled customers of one bank to use their cards at the ATMs of other banks. The EFT networks didn’t have a system for authorizing card transactions by signature. But they could authorize and settle transactions if merchants had PIN pads that were connected to the ATM switches. And most of the EFT systems required banks to allow ATM cards to be used for retail transactions. To get merchants on board, the EFT networks had to convince merchants to install PIN pads. They did this by setting an interchange fee that was much lower than that charged by the card associations. This resulted in merchants with PIN pads paying a much lower merchant discount for PIN debit transactions than for signature debit transactions.
Most banks chose to put the marks of either MasterCard or Visa (for signature debit) and the EFT networks (for PIN debit) on the same card. This resulted in synergies between signature and PIN debit. The existing base of ATM cards made it easier for banks to issue Visa Check cards, while the Visa Check promotions helped persuade people to carry and use these cards—in both modes—for paying for things. Despite these synergies the card associations and the EFT networks waged war to capture consumer transactions. That and the competition between MasterCard and Visa for banks to issue their debit cards is one of the subjects of a later chapter on the system wars.
The efforts to increase debit card use, by both Visa and the EFT networks, were successful. By 2002, debit cards accounted for 29 percent of both all payment cards and all payment card volume. Of the $572 billion worth of transactions on debit cards in 2002, about two thirds were signature debit and one third was debit. Debit cards became an important part of the package that banks provided to consumers. In addition to providing interchange fee revenues, these cards helped banks acquire checking account customers who then typically used the bank for various services ranging from brokerage accounts to personal loans to mortgages.
While the rapid growth of debit cards was by far the most notable change in the payment card industry in the 1990s, four other developments deserve mention. The first was a financial innovation known as “securitization,” which enabled credit card lenders to sell credit card debt to other institutions that could consolidate many different kinds of debt from many different lenders. Credit card issuers could use securitization income to expand their businesses. Securitization also allowed assets to be moved from the card issuers’ balance sheets, thus lowering the capital reserves they were required to hold. In addition, credit card issuers could reduce their risk from cardholders defaulting on payments—a particular worry in the event of an economic downturn. Without securitization, an individual issuer, especially those that focused on credit card lending, had difficulty diversifying away their risk exposure. Securitization allowed lenders to diversify their risk and thus to extend credit deeper into the pool of relatively risky consumers (that is, consumers with poor credit histories). Industry experts estimate that $61 billion in retail and bank credit card loans, roughly 10 percent of outstanding balances on store and bank credit cards, were securitized in 2001. (This development came later than, but is similar to, the securitization of mortgages. Most mortgage lenders resell their loans to companies that consolidate loans from many lenders and then diversify the risk through complex financial arrangements.) Securitization also made it easier for companies to both enter credit card lending (because they could diversify their risk) and get out of the business (because they had a market for the loans they had made).
The second key development occurred in the banking industry. We saw in the previous chapter that legislative changes resulted in a massive consolidation of banks. This had effects on the payment card industry. Consider the fifty-largest banks ranked by total assets in 1990. Through mergers and acquisitions, these fifty banks were consolidated into eighteen banks by 2003. For example, Chase Manhattan took over Chemical Bank in 1996. Bank One acquired First USA and First Chicago in 1997 and 1998, respectively, and Bank of America—one of the largest bank credit card issuers—merged with NationsBank in 1998. This automatically led to consolidation among payment card issuers. Moreover, there was substantial consolidation within the card industry through portfolio sales. AT&T Universal sold off its portfolio to Citigroup in 1998, for instance, and MBNA purchased the SunTrust Bank portfolio in 1999. Additional shifts have occurred as some issuers have substantially increased their share of sales volume. For example, MBNA more than doubled its share of Visa and MasterCard credit card volume from 4.5 percent in 1990 to 10.8 percent in 1999. The payment card industry became more concentrated—the top ten bankcard issuers accounted for 74 percent of Visa and MasterCard volume in 1999 versus 44 percent in 1990.
A third development concerns the co-opetitives. During the 1990s, each co-opetitive began aggressively encouraging its members to dedicate themselves to one association at the expense of the other association. By the end of the 1990s, both MasterCard and Visa began to offer formal partnership programs, providing benefits to banks that agreed to focus their card business on just one system.
Finally, one can’t talk about the 1990s without mentioning about the emergence of the commercial world-wide web in the middle of the decade. Cards were the perfect payment instrument for online transactions and quickly became the main way to pay on the web. We treat online payments in detail in Chapter X and defer further discussion until then.
The general-purpose payment card turned fifty in 2000. Despite all the talk about the cashless society, this electronic method of payment still accounted for less than half of all retail transactions, and only 27 percent of all consumer expenditures—this excludes implicit consumption that doesn’t involve payment, such as the rent you pay yourself if you own your home. Cash and checks still hadn’t disappeared.
Figure 3.4: Purchase volume on general-purpose payment cards as a percent of consumer expenditures, 1970-2000
Note: General-purpose payment cards include credit, charge, PIN debit, and signature debit cards. Sources: Bureau of Economic Analysis; and The Nilson Report (various 1970-2003 issues).
The move to electronic money had been gradual, but steady during the first half century. Figure 3.4 shows the purchase volume of general-purpose payment cards as a percentage of consumer expenditures in the United States from 1970 to 2000. (Comparable data are not available before 1970. The percentages would have been miniscule during the 1950s and through much of the 1960s.) The payment card industry had evolved through incremental changes that persuaded more individuals and businesses to rely on this method of payment. There had been some drastic innovations—McNamara’s initial insight, and the idea of bundling revolving credit with a payment device, and the ignition of debit. But modest innovations had also been important in aggregate. These include the use of computers to reduce the time it takes to complete transactions, the development of credit-scoring techniques to identify and then monitor creditworthy customers, securitization, and bundling airline rewards and other features onto cards.
Standing at the end of the 1990s one might have thought that the payment card industry, at fifty, had reached maturity, that its sixth decade would be relatively calm. It was not to be. By 2010 the MasterCard and Visa associations had dissolved themselves and reemerged as publicly traded companies with market caps, when combined, of around $85 billion—three times larger than eBay and almost 60 percent as large as Google. Credit cards showed their age as debit cards soared and prepaid cards lay the basis for considerable innovation in payments. The industry ended the decade under siege as Congress, responding to a barrage of complaints from consumer and merchant groups and profoundly cynical about financial service providers, imposed intrusive regulations. Yet, while old ways were under challenge, innovation accelerated as a result of developments with mobile, software and internet technologies. Many industry participants ended the 2000s with fright and delight as they dealt simultaneously with significant business risks and substantial new opportunities.
Death by Association
By the turn of the century the bank associations that had spurred the growth of cards through network effects for three decades were facing serious business and legal issues.
The credit-card associations were clubs that bank members belonged to. Like any club management spent a far amount of time making sure that the members were on board with their various initiatives. And, like any club, there was an inherent tension between management, which had to set and enforce membership rules, and the members who could vote management out. These clubs became harder to run during the 1980s and 1990s as a result of increasing tension between the bank members and between members and management.
In the late 1960s and 1970s credit-card issuers were fishing for customers in a very large ocean. Before the Marquette decision opened the way for national card issuance these many of these banks were also fishing far away from each other. By 2000 10 large banks accounted for X percent of transaction volume on cards. They issued nationally and competed at least in part for the same customers. Securing cooperation among these rivals became harder for the managements of MasterCard and Visa.
At the same time the larger banks became better able to seek advantages for themselves from each association by threatening to take their card portfolios to the other association. That wasn’t possible in the earlier days. Even the withdrawal of the largest members of MasterCard and Visa wouldn’t have had a noticeable effect on the financials of these associations in the 1970s and 1980s. By 2000 X banks each accounted for at least 5 percent of the card volume for Visa and X for MasterCard. While these banks belonged to both associations they could threaten to move their volume over the other association if they didn’t get what they wanted in return.
Citigroup did just that. Several banks including Citi wanted Visa to give the bank brand more prominence on the card. Up to that point in time MasterCard and Visa cards highlighted the brands of the association. That made sense during the years in which all banks benefit from the expansion of these card brands in the United States and, indeed, around the world. But as the banks became bigger and more ambitious rivals, and the MasterCard and Visa brand names were engraved in the minds of the public, some of the banks wanted the ability to give themselves a larger piece of the real-estate on the plastic card. Despite Citi’s threat to bolt Visa refused to relent to Citi’s demand over this or other issues. This national issuer, with an X percent share of US card volume in 1998, made good on its threat and started that year to move its U.S. card volume over to MasterCard. That was a financial jolt to Visa and to its members who had to bear a greater part of the cost of the system.
Ironically, it is easier to manage a club with many small members than one which a handful to members who are trying to seek advantages for themselves. These “clubs” had that worked well for many decades became a victim of their own success as some their members became very large.
The associations had been flypaper for litigation almost from their beginnings but the risks had become both more palpable and larger in the early days of the new century. Even without the management challenges MasterCard and Visa had little choice but to kill the associations and reincarnate themselves as public equity corporations.
The antitrust laws of the United States and many other countries are rightfully suspicious when firms that compete with each other get together and agree to do things. The most severe antirust sanctions are imposed on “cartels” in which competitors get together to fix prices or divide markets. Yet the U.S. Supreme Court has recognized that under certain circumstances cooperation among competitors may generate value for consumers. The European Union’s antitrust laws also allow firms to cooperate when they can show, in effect, that this is essential for providing benefits to consumers. Over the years the courts and regulatory authorities have struggled with deciding whether these associations of banks rivals are restricting competition or engaging in necessary cooperation that promotes economic efficiency. But any action that MasterCard and Visa take can be subject to a lawsuit, or a complaint to an antitrust authority, that the banks are violating antitrust laws that prohibit competitors from acting together. The burden then falls to the associations to prove that they should get a pass.
The greatest controversy over the years has surrounded the interchange fee. MasterCard and Visa set the fees that members that acquire merchants have to pay members the acquire cardholders when a cardholder uses her card to buy something at a merchant. Antitrust and bank regulators around the world started looking at interchange fees in the late 1990s. Then, in 2005, a group of retailers in the United States, including many large ones, filed class-action action cases against MasterCard and Visa accusing them of having engaged in price fixing and other violations of the antitrust laws. It became apparent early in the decade that the associations were going to be embroiled in litigation and regulatory proceedings over the setting of interchange fees for years, that interchange fees in various part of the world could be prohibited or regulated, and that in the United States at least associations (and their members) could face massive damage awards. MasterCard and Visa agreed to pay about $3.3 billion in 2003 (in 2008 dollars) to settle another merchant class action. The merchants had claimed that the card networks have restricted competition by “tying” credit and debit cards—merchants had to take both to get either.
The legal issue at the heart of these lawsuits results almost entirely from the association model that MasterCard and Visa adopted. The interchange fee largely determines the fee that merchants pay because it is passed on from the acquiring bank to the merchant. Go-it-alone systems such as American Express can set the merchant fee for their cards. They are just setting the price they are charging customers. They can also set the portion of the fee that they share with banks that agree to issue American Express cards. MasterCard and Visa were vulnerable to lawsuits largely because members that competed with each other were acting through the association to set the interchange fee.
The banks that owned MasterCard and Visa decided to end their associations. MasterCard went first in 2006 and Visa next in 2008. In both cases these card networks reorganized themselves as public equity corporations and did initial public offerings in which a majority of the stock was sold off. Banks retained some stock, continued to have representation on the boards, but removed themselves from any decisions concerning interchange fees. These IPOs allowed the banks to cash-in on their participation in the card associations. By allowing these organizations to raise capital in the public markets, and eliminating the cumbersome association management, the banks likely increased the value of MasterCard and Visa and thus their own stakes. And finally, by removing the banks from a decision making role over interchange fees the banks arguably reduced their exposure to litigation involving price fixing claims. (The plaintiffs in the US class-action litigation and the European antitrust regulators, however, continue to claim that the banks are colluding unlawfully in the setting of interchange fees.)
Another significant change in the role of card networks occurred in the 2000s as a result of a lawsuit that had been filed by the U.S. Department of Justice. The courts ruled that it was unlawful for MasterCard and Visa to prohibit member banks from also issuing the cards of competing associations. (American Express had already been issuing cards through MasterCard and Visa member banks outside the United States where the association gave in to the threat of litigation.) American Express and Discover both have “network” divisions which enter into agreements with banks to issue their cards. For the United States, these usually go-it-alone systems have not reported how much of their card transactions occur on cards issued by bank partners although there is no evidence that it is significant as of 2010. (Outside the US American Express reports that 68 percent of its transactions occur on cards issued by third-parties on its network.)
Pay Before and Pay Now
For its first half century the defining characteristic of the American payment card industry for consumers was that when they used a card they didn’t have to really pay until later. The tide turned in the 2000s.
Debit cards use grew explosively. By the middle of the decade, debit cards accounted for more than half percent of all general purpose card transactions and more than a third of all dollars charged to cards. For Visa, the first quarter of 2009 marked a significant turning point: debit card charges exceeded credit card charges for the first time.
Credit cards allowed people to pay later by writing a check for the funds they were advanced today to buy something. Debit cards enabled people to pay more or less right away by having funding taken out of their checking accounts. The timeline was completed by a product that was developed in the mid 1990s but became widely developed in the 2000s: the prepaid card that allowed people to commit funds to a card and have purchased deducted from that account. The concept of “pay before” cards became the mother of invention in the card industry: it spawned some of the most important innovations in payments, from enabling the widespread disbursement of funds to the largely unbanked victims of Hurricane Katrina, to providing a low-cost way for companies to pay their employees, to helping immigrants to get funds cheaply to their families back home.
American retailers started replacing paper gift certificates with plastic gift cards in the mid 1990s. Blockbuster was the first in 1995. A gift giver could buy a gift card that had a designated amount of funds attached to it. The recipient of the gift card could then use that card to buy items at the retailer until they had exhausted the funds on the card. Other retailers such as Starbucks introduced cards that could be reloaded with money. People could buy the cards for themselves, or give them away, and pay for items at the retailer. (Retailer prepaid cards are often called “closed-loop” cards there is a direct flow of funds between the merchant that issued the card and the consumer who uses the card.)
General purpose prepaid cards were introduced at the turn of the century by the major card networks. Once loaded, cardholders could dip into the funds for these cards at any merchant that accepted the card brand. Moreover, some of these general purpose prepaid cards were linked with a PIN-debit network so that consumers could withdraw funds at almost any ATM. Many uses were found for these prepaid cards and they are often referred by their particular use.
Issuers persuaded some employers—sometimes working through the payroll processing firms that employers use—to give their employees “payroll cards” and make their wages accessible through these cards. The employer would use the ACH system to deposit wages into an account at the prepaid card issuer. The employee could then use their card to either pay for things at merchants that accept the card brand or to take money out of ATMs. Payroll cards are particularly helpful for employees that don’t have bank accounts.
Prepaid cards were also appealing for the unbanked more generally. Aside from convenience, by the 2000s it had become difficult for a consumer to carry on the ordinary business of life without a plastic card. They were essential for buying things online, a few places had stopped accepting cash, and some transactions required a card for a security deposit. The unbanked overlapped significantly with another group of people who bound prepaid cards useful: immigrants who wanted to transfer funds to family in friends in other countries. They could do this through money transfer services such as Western Union but these services, which rely on labor-intensive networks of offices throughout the world, were expensive. Prepaid card issuers introduced cheaper card-based alternatives.
Prepaid card solutions were also developed for governments and non-profits. Many states use prepaid cards to distribute benefits such as food stamps. Visa alone ran 70 state prepaid programs in 38 states in 2009. They load child support, workers comp and unemployment insurance payments on these cards. The American Red Cross provided massive assistance to the Hurricane Katrina victims on prepaid debit cards from MasterCard and JPMorgan Chase and is using these cards as part of its general relief efforts.
Although there is a consensus across many data sources that prepaid cards have grown over the 2000s there are no reliable estimates of the amount of spending that takes place on these cards. (That is because the main data collection schemes cannot readily distinguish between prepaid and debit cards.) A detailed study sponsored by the Board of Governors of the Federal Reserve estimated that, in 2006, consumers charged $58.3 billion on retailer and general purpose prepaid cards. Most of the prepaid spending, 73.3 percent was on retailer cards. Prepaid cards accounted for a small portion of overall payment card spending mid decade. Retailer and general purpose prepaid cards amounted to 1.6 percent of total spending on all retailer and general purpose payment cards in 2006. General purpose prepaid cards accounted for only 0.5 percent of spending on general purpose payment cards.
The Financial Crisis and the New Rules
The decade ended with Congress imposing extensive regulations on the payment card industry that that could have far-reaching consequences on the business in the coming years.
Cardholders complained about issuers charging then hefty late fees while giving them little time to pay their bills. Issuers were getting more of their revenues from these soft of fees. As a percent of total card revenue “extra fees” that didn’t involving interest charges for revolving loans or annual fees for having the cards had increased from [XX] percent in 2000 to [XX] percent in 2009. Consumers were also irritated by banks increasing interest rates on their cards without notifying them and applying these higher rates to existing balances. The press highlighted extreme cases of bad behavior by issuers and consumer advocates agitated for relief.
Meanwhile, merchants, the other half of the two-sided payments business, became increasingly vociferous about the fees they had to pay when consumers paid with plastic. Their bills had increased over the decade in part because interchange fees had increased (from [XX] percent on average in 200X to [X.X] percent in 2009) and because consumers were paying more with cards (in particular with debit cards). In addition to pursuing an antitrust lawsuit they lobbied Washington for relief.
We will never know whether Congress would have adopted legislation to deal with either of these issues if the financial crisis hadn’t hit in 2008. The banking industry was blamed for having caused the Great Recession and forcing taxpayers to fund massive bailouts to stem financial collapse. Calls for financial reform soon followed. Although the crisis was largely caused by the burst of a housing bubble the payment card industry was swept along in efforts to devise stricter regulations for banks and curtail what some thought as excessive credit.
The Credit Card Accountability and Disclosure Act (CARD Act), signed by President Obama in May 2009 after having won bipartisan support in Congress, regulated many aspects of how issuers could charge consumers. The Act prohibited some practices such as raising interest rates in the first year after a consumer has opened a credit card account, charging for exceeding limits, and setting early morning deadlines for payments. It also required issuers to give consumers at least 45 days notice of increase in interest rates and to mail bills at least 21 days in advance of the due date of the payment. Credit card companies complained that the legislation limited their ability to charge more to riskier borrowers. Although systematic data on the results of the legislation are not yet available there were reports that banks raised card fees and interest rates to cover their lending risks and reduced lending to riskier borrowers. They were able to respond that way because the CARD Act did not limit their fees—only the timing of them.
Slightly more than a year later Congress, divided along party lines, passed the Wall Street Reform and Consumer Protection Act which was signed by President Obama on July 21, 2010. Two parts of this legislation, which was the major effort to reform financial regulation in light of the crisis, affect the payment card industry.
The most direct is a section which calls for “reasonable fees and rules for payment card transactions.” The Federal Reserve Board is supposed to make sure the debit card interchange fees are reasonable and proportional to the costs incurred in making the transaction. That applies to signature and PIN debit as well as most general purpose prepaid cards. Since banks typically earn most of their debit card revenue from merchants rather than cardholders these rules will likely reduce interchange fees, especially for signature debit, substantially. The Federal Reserve is supposed to have its regulations in place by the end of March 2011.
The legislation also creates the Consumer Financial Protection Board (CFPB), within the Federal Reserve Board, which is responsible for regulating almost all consumer financial service products including all payment cards. In part, the CFPB takes over existing responsibilities under past legislation from various federal agencies. But it also has new powers to prevent financial service companies from engaging in “abusive” practices. The legislation furthermore allows states to adopt and enforce more stringent rules and laws than those adopted by the federal government. It remains to be seen how this new agency will affect the card industry. It will take time for it to be established and much of its powers are vested in its director who will be appointed by the President and confirmed by Congress.
Inflection Point
Shortly after the start of the financial crisis eBay bought BillMeLater for almost $1 billion in cash and stock with plans to add it to its PayPal business. BillMeLater provided credit to consumers for online transactions. Consumers who shopped at merchants that offered this alternative could seek an almost instant credit approval for their purchase. That might involve a revolving loan or an installment purchase. If they got it they got the good and got the bill later. In late 2009 American Express spent $300 million to buy Revolution Money which used Web 2.0 technology to provide cards online and as well as in the physical world. Less than two years later Visa bought Cybersource, a company that provided various technical services to online merchants, for about $2 billion. These transactions were proof of what was widely known in the payments industry. These transactions sent a message to entrepreneurs and investors in the payments business: innovation could have big payoffs.
The business of using cards for buying and borrowing was ripe for new ways of doing things at the end of the decade. Most importantly, the walls between the online and physical worlds were falling. For most of the web economy’s short history there was a sharp distinction between shopping online, which people did sitting at their desktop computers using a browser, and at bricks and mortar stores that people drove or walk to and where they could touch what they were thinking about buying.
By 2009 about 91 percent of American households had mobile phones and about 38 percent of subscribers used them to access the internet. The percent of consumers with smart mobile phones—basically small computers with a graphical user interface and a browser—such as the iPhone was increasing rapidly. A few of the new payment services pointed toward future possibilities with the mobile devices. People could use PayPal—the quintessential online payment method—to rent a lawnmower (through a new company called Rentalics that relied on PayPal for payments) or to split the cost of a meal at a restaurant (through the iPhone bump application) with a few taps on their smart phones.
Merchants also started seeing the possibility of using internet technology to accept payments at the physical point of sale. They had relied on private networks and devices that came bundled with software. The company Square introduced a new payment system that enabled merchants to accept payments using internet-connected mobile devices such as the iPad or Android phones. They provided an attachment to these devices through which merchants could swipe cards. The transaction was then sent to the merchant processor over the internet.
For most of the previous century Americans used some form of “card”, whether metal, paper, cardboard, or plastic, to identify themselves to merchants. The mag stripe plastic card was the predominant method for paying at merchants in 2010—despite a well-funded effort by the card networks to persuade merchants to install equipment to take contactless cards that consumers could wave at terminal. Swipe transactions took just a few seconds to complete. Yet many were betting that the mobile phone would topple the card. They just weren’t sure how or when.
As cards entered roughly their second century and the general purpose payment card turned sixty, paper was still not vanquished. Almost half of consumer expenditures—even excluding mortgages and rent—were paid with cash or check or some other paper method of payment. That means that the electronic payments industry, and the general purpose card portion of it, continues to have significant opportunities for growth.
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