The dwindling relevance of the credit cards business model

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A decade back, the allure of the credit card business in India was comprehensible. India stood ahead of only Russia and Indonesia in using cash for transactions – with a 70 percent market share, compared to 20 percent in the US and 11 percent in the UK. The prevailing belief was that India would inevitably emulate Western trends, witnessing the digitization of its economy, thereby presenting a significant advantage for the credit card sector.

The credit card business in India faces a different landscape now, both in the medium as well as the long term. In the longer term, digital alternatives will limit credit card market potential, while technological innovations will challenge its business economics. In the medium term, rising delinquencies pose a significant risk that the market is underestimating. A careful assessment of the industry's prospects is crucial to navigating these challenges effectively.

The credit card economics

The global electronics payments processing industry has two major players (Visa and Mastercard) and a few smaller ones (American Express, Discover, and JCB). Merchants are charged for every transaction (merchant discount rate, or MDR), and the proceeds are shared by the initiating bank, the terminating bank and the intermediary.

The company's expenditure for acquiring a cardholder varies between Rs 3,000 to 4,500 across different channels. On average, a cardholder will spend Rs 140,000 per year, of which Rs 28,000 are converted into loans. But not all loans earn interest.

A significant portion, 40 percent, of these loans is attributed to "transactors" – customers who diligently pay their monthly bills on time and thus are not subject to interest charges. While credit card companies earn MDR from these transactors, they are provided interest-free loans equivalent to one billing cycle. Financially, this arrangement poses challenges and is not an optimal proposition for credit card companies.

Approximately 35 percent of these loans are expected to be converted into EMIs, subject to an interest rate close to 20 percent. Meanwhile, the remaining 25 percent of loans are attributed to "revolvers," who opt to pay the minimum amount due presently and carry forward the outstanding balance, subject to an interest rate of over 30 percent. This segment is where credit card companies generate profits, but it also comes with the risk of some of these loans turning bad or defaulting.

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On average, each card generates Rs 3,700 in net interest and approximately Rs 4,400 in fees. Nevertheless, these earnings are counterbalanced by three types of costs – (a) Spend-based costs and marketing: Rs 3,300, and (b) Bad debts (historically 5 percent of assets): Rs 1,100. After factoring in these costs and taxes, the post-tax earning per card amounts to Rs 2,700.

The prospect of an incremental Rs 4,000 investment yielding Rs 2,700 in returns is indeed an attractive business proposition. Moreover, when the addressable market is extensive, it can be argued that such a business deserves premium valuations.

Challenges over the medium term

In the medium term, the growth of the Unified Payment Interface (UPI) surpasses that of the credit card business in India. The Indian digital revolution was in progress for several years, supported by India Stack's open APIs and digital public goods. The introduction of UPI in 2016 provided a significant boost to this revolution. Unlike credit cards (1.5-3 percent MDR) or debit cards (0.5-1 percent MDR), UPI does not charge merchants. Customers link their bank accounts to UPI, eliminating the need for credit assessments, which is particularly beneficial to customers lacking credit histories. Consequently, UPI dominates in small-ticket transactions.

Indian retail digital payments surged to Rs 62 trillion in May 2023, doubling since June 2020. While card usage slightly improved (market share over 2 percent), UPI's share tripled to over 24 percent.

Challenges over the longer term

Nonetheless, our digital journey has only just begun. India Stack's ultimate objective is to deliver digital services by addressing four crucial challenges: (a) streamlining customer identity verification and eliminating cumbersome paperwork, (b) reducing the reliance on physical cash, (c) safeguarding user data, and (d) extending low-cost credit to unbanked regions.

The Jan-Dhan, Aadhar, and mobile (JAM) trinity, along with UPI, have addressed some of the challenges. In the coming decade, as additional layers are integrated, the 'loans ecosystem' will undergo a complete redefinition. The upcoming layers in the stack are account aggregators (AA) and open credit enablement network (OCEN). RBI already regulates AA NBFCs, acting as data aggregators (currently housed individually by lenders), and utilizing this data to 'democratize credit' through OCEN (already launched in 2020).

Suppose an SME with limited credit history seeks a small loan amount, below the interest threshold of banks or NBFCs. The OCEN network serves as a platform for loan service providers (LSPs) to streamline operations and enhance efficiency, thus reducing costs. Upon full implementation, these innovations aim to bring over a billion individuals into India's formal credit network.

Indeed, this presents a significant opportunity (a vast market) for existing players. However, it also carries substantial risks, as data democratization and open sharing can diminish the competitive advantage ("moat") traditionally enjoyed by these players.

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Challenges over the short term

Despite credit costs stabilizing for most lending institutions, the credit card business still faces persistent challenges. In the fourth quarter of fiscal year 2023, the credit costs, measured as a percentage of net loans have stayed above the average of the years 2013-2019 (pre-COVID period). The situation remains far from returning to normal, in my opinion.

In summary…

For us, the credit card product is a combination of (a) payments and (b) loans. For low-ticket items, UPI already beats cards hands down. The question is, can it be replicated for bigger amounts? Separately, a 21 percent blended interest rate and a business that generates over 25 percent ROE is superlatively high. As the credit starts getting democratized, credit card companies will likely lose their moat (customer data garnered over years of operations) and new fintech players will eat into their very lucrative market.

Over the next decade, the complete implementation of India Stack is anticipated to revolutionize the entire payment ecosystem in India. New business models will emerge, and existing players will face the imperative to adapt or exit the market. The credit card business model, which could potentially benefit from segmentation into payments and credit, is likely to become a subject of significant debate. While the short-term pain will eventually ease (credit costs go lower), it would be very interesting to see what happens to this business over the longer term.