## Saturday, December 20, 2008

### Economics of Credit Card & Debit Card

What is substitute good? How do we know if two goods are substitute of one another?

Substitute good is good that can be used in place of another. There are many types of substitutes, with some strong & some weak in relation. Weak one could be tea & coffee (XED near 0), moderate (XED around 0.5) such as McDonalds & Burger King & strong ones like Pepsi & Coca-Cola (XED near 1)

Substitute goods have POSITIVE cross elasticity of demand (XED more than 0). It is given by the formula,

XED = % change in quantity demanded for good A/ % change in price of good B

XED is necessarily positive due to the mathematical relation. For e.g. if the price of a Coke increase (positive % in price), people will drink lesser Coke & switch over to drinking Pepsi (positive % in quantity demanded).

As such when a positive numerator is divided over a positive denominator, the outcome is always positive. The outcome such as 0.2, 0.35, 0.9 etc is the strength of substitubility

Is debit card a close substitute to credit card?

Yes

(1) Low fee vs. high interest rate charge. These 2 act as price. Since credit card charge is much higher, in theory people will demand lesser credit cards & more will switch over to debit card. To strengthen the argument, debit card fee will always be lower than credit card charge since, the former involves customers drawing money from their own account while the latter is borrowing from the bank. It does not make logical financial sense, if you’re being charge higher for taking out your own money

(2) High cash transaction. In Malaysia, the proportion of cash transaction to non-cash transaction is 4:1 (The EDGE, Dec 15) & this means that general public still prefer to pay out of their own wallet rather than relying on credit from banks. As such, the market for debit card is vast & there is huge potential to tap this segment. According to MasterCard Worldwide, in the event of economic slowdown, debit MasterCard posted a 22% year-on-year growth in worldwide transaction value to US\$ 554 billion, with 6.87 trillion transactions

(3) Increasing applicants. In the recent months, banks have begun to promote debit cards more aggressively than credit card. First, they realised that the market for this plastic card is huge. Secondly, credit card market could have reach saturations after so many years of aggressive pick up. Here, debit card issuance is around 15, 000 every month & that is fast growing

(4) People realised that it is difficult to control spending appetite. There is a high tendency for credit card applicants to overspend beyond their means. Coupled with high interest rate charges, the amount of money we owe could skyrocket in matter of months. Although there is a ceiling imposed by banks, more often than not it is set at quite a high level & thus encouraging overspending. Once switched over, the fear of hanging with debt load will be eliminated as every swipe comes from one’s savings account

No

(1) 24 hours charging limit. Some debit cards may limit spending in a day. As such if someone who wish to purchase huge items, they may not be able to do so

(2) Credit card is more superior if you spend wisely. Not all the time credit card users are hit with high charges for not settling the bill each month. Sometimes the lender will give applicants a break in the form of float. Float here means a grace period that we have, to avoid interest on a purchase if there is no balance in our cards at moment of purchase.

(3) Attractive rewards for using credit cards
. Increasing number of credit card companies or banks offer various benefits, annual fee waivers, attractive cash & non cash prizes such as cars just to attract more applicants. At moment of writing, debit card is about to expand in Malaysia & its attractiveness is not towards as ‘developed’ as credit card. Furthermore, banks can rely on the demographic dividend that we have & that is increasing number of young executives. As such one could argue that the vast different in rewards to card holders, reduce the level of substitubility between the 2

Benefits to debit card applicants

(1) No fear of overspending. With every swipe, monies will be deducted from the users’ bank account. There is always a limit to how much one can spend, unlike in credit cards (limits are set too high)

(2) Reduce costs of obtaining cash
. There is no such hassle to walk or drive to the nearest ATM machines. That reduces cost like time wasted, petrol etc

(3) Everyone can apply for debit card. As long as one having a savings account, he or she is entitled to debit card. Also there is no age restrictions & income requirements. This truly benefits those working people whom may have income below requirement & thus not eligible to apply for credit card

Benefits to banks/ issuers

(1) Cross-selling other products. Applicants for debit cards will definitely need to have a savings account with the bank. As such the bank is said to have cross-sell other of its banking products. Also, this could be a source of funding for banks to generate lending

(2) Greater supernormal profits.
Although the bank may not earn much fee with every swipe, but owing to the vast potential of the market, it means higher transactions which automatically means greater revenue & therefore supernormal profits

(3) No risk of NPLs (non-performing loans). Debit card is a safe products for banks. It would not add to defaults like what we have for credit card. This is because monies are deducted from users account. Unlike the latter, monies are borrowed from banks & as such inability to meet timely repayment or default can adversely affect banks’ balance sheet