Intermediaries to a Credit Card Transaction

In the past couple of decades, banks have started providing a new type of product called the credit card. The credit card is a revolving line of credit which is offered to customers. Customers can use the card to borrow money to make purchases. They are then offered a credit free period. If they are able to pay back the bank within the credit free period, no interest is charged. However, if the customers exceed the credit free period, an interest fee is charged. Since these loans are highly risky and unsecured in nature, banks charge a very high rate of interest on the balances outstanding on these cards.

In a very short period of time, credit cards have come to dominate the modern banking landscape. They are today one of the most popular products offered by banks. An average American has anywhere between 10 to 13 credit cards. Also, the idea of credit cards is fast spreading to developing countries. In this article, we will understand the reason why credit cards have become so popular as well as list down the parties that are involved in a transaction.

Rationale behind Credit Cards

For a transaction to be processed successfully on the credit card, at least 4 to 5 parties have to be involved. Each of these parties charges a fee in order to provide a service. As a result, transactions conducted on credit cards are on average 2% to 3% more expensive than the same transactions being conducted in cash. This additional expense has to be borne by somebody. Usually this expense is borne by the merchant. Therefore, by accepting credit cards, the merchant is literally reducing his profits by 2 to 3 percentage points.

This raises the question as to why would any merchant want to accept payment via an expensive credit card network as opposed to accepting cash. The answer lies in human behavior. People who spend on credit cards tend to spend more than people who pay cash. Therefore, by accepting credit cards stores end up increasing their sales significantly. Hence, even if a certain amount of fees is charged, they do not mind paying the additional fee.

The consumer therefore gets free credit, the bank gets a fee and the merchant gets increased sales creating a win-win-win situation. This has made credit card the darling of bankers and the growth engine for the matured and stable banking industry.

Any credit card transaction involves multiple parties. Apart from the cardholder and the seller i.e. the merchant, at least 4 different types of parties are involved in the process. Their roles have been listed below.

Merchant Bank

A merchant bank is the bank with which the seller i.e. the merchant has an account. This bank is also known as the receiving bank since it receives the payment at the end of the settlement process. Also, it is known as the acquiring bank. This is because merchant banks have to go and make sales to the merchants. They have to convince the merchant to install a point of sale device at their shop and start accepting credit card payments.

Issuing Bank

The issuing bank is the bank that is involved in the transaction from the customer’s side. This is the bank that is providing the credit for the transaction. Also, this is the bank that keeps a record of the customer’s transactions, bills it and receives money from the customer. This bank maintains details of the customer’s account and authorizes payments only if credit is available in the customer’s credit account. Also, this bank is in charge of collecting payments from customers along with any interest if due.

Networks

Any credit card transaction requires transmission of several messages amongst several parties in a matter of seconds. First an inquiry needs to be sent to the issuing bank, then the authorization needs to be received from the bank, also merchants need to send their daily sales for settlement in the form of a batch at the end of the day.

This consistent processing requires high end technological networks to be in place. Hence, there are network companies which are also involved in the credit card business. These companies basically rent out their infrastructure every time a transaction is made and charge a fee for doing so.

Associations

Lastly, there are associations like Visa, MasterCard, American Express and Discover. These associations have different banks as their members. They facilitate the payments between the member banks. Thus, these networks help the issuing bank and the acquiring bank to settle their records. These two banks then have to deal with customers and merchants on their own respectively.

The credit card mechanism is a technological marvel. It provides instant credit to its users and provides the convenience to track their spending patterns without any effort. However, credit cards have landed into significant controversy because of the usurious interest rates that are charged on outstanding balances as well as the tough measures that are taken to collect dues from customers. If moral issues are left aside, credit cards have indeed been the most significant innovation in the retail banking industry in the past century or so. However, when moral issues are considered, the situation changed completely!