Banks fund their credit card portfolios in a way that often surprises the public. Many people believe that when they make purchases with their credit cards, the bank has the necessary funds readily available. However, this is generally not the case. Instead, banks receive daily updates on credit card activity and must borrow funds to cover any additional balances.
For instance, if you buy a car for $25,000 using your credit card, the bank borrows the money to finance that purchase. The bank benefits by charging fees for the transaction and collecting interest on any outstanding balance. While the bank pays interest on the borrowed funds, it earns a profit from the difference, known as the spread, between the interest rate you are charged and the rate at which the bank borrows.
For example, if the bank charges you an 18% interest rate for maintaining a balance and pays 5% on the borrowed funds, the bank earns a spread of 18% - 5%, which equals 13%. Additionally, credit losses—typically around 4% to 5% annually—further reduce this spread. On its balance sheet, the bank records your outstanding balance as a receivable while the borrowed money to fund your purchase is listed as a liability.
The bank will consolidate your charges and outstanding balances with those of other cardholders and manage the funding for the total credit card balances. It will provide financial support for the entire credit card portfolio through both overnight and term funding. This responsibility of managing assets and liabilities falls under a treasury group, which will oversee the recycling of assets and liabilities, as well as the interest rate risk associated with funding these credit card receivables.
The treasury function becomes more complex by utilizing futures contracts that are designated as hedges to secure expected rates for future funding. Gains and losses from these futures contracts, when used as hedges, are marked to market, although this is not for income statement purposes. The profits and losses from these hedges are deferred until the associated liability is incurred, after which the gains and losses are amortized over the life of the funding.
The process of lending and borrowing to finance purchases is called financial intermediation. In this process, banks expand their balance sheets on both the asset and liability sides, leading to overall growth. Regulators limit this growth by enforcing minimum net capital requirements, which are calculated as assets minus liabilities.
