Shaping a Nation of Credit Cards

Most Americans during the 1800s lived with basic necessities. Towards the end of the 19th century, new, technologically advanced goods like cars, telephones, sewing machines, and refrigerators emerged, offering obvious advantages. However, these items were often unaffordable for many people.

To address this, merchants, manufacturers and banks introduced installment credit, allowing consumers to pay for goods in small monthly installments. This made expensive items accessible, boosting sales significantly. By 1930, a majority of durable goods were sold on installment credit. But lending money was not without cost: merchants had to assess each individual customer's creditworthiness, bear the risk of late or nonpayment, and manage all of the back-office headaches and expenses like billing/collection, postage, stationery, and customer service.

Remember, this was a time when advanced computers and automated systems were not available.

Thus, banks avoided making small loans in the first place, except for one bank - Bank of America, which by 1950s had grown into the largest bank in the country and it became so by being the one bank willing to lend to middle-class consumers via installment credit.

But they were also suffering from the cost of management of this process – the reams of paperwork; salaries of tens of thousands of loan officers and thus they decided to make this process more efficient and started looking for a better way.

During the same period, Diners Club (the world’s first credit card - that’s a story for another day) was getting everyone's attention.

Thus, Bank of America decided to launch their own credit card, seeing it as a way to provide customers with an instant, no-questions-asked personal loan and reduce the time and back-office costs associated with processing these loans. They launched “BankAmericard” on September 18, 1958, in Fresno, CA, with a twist: unlike Diners Club, Bank of America's card wouldn't require customers to settle their bill in full each month.

Instead, their card offered revolving credit, allowing customers to carry a balance and make flexible payments. For example, if someone bought a $200 appliance, they could choose to pay $50 a month, with the remaining balance carried over to the next month, rather than paying the full $200 immediately.

Initially a failure, the program faced rampant fraud, late payments from 22% of cardholders, and resistance from large merchants, resulting in a $20 million loss within 15 months. Despite these early setbacks, Bank of America turned the program profitable after three years, dominating California and creating a virtuous cycle: more cardholders led to more spending, attracting more merchants, which in turn increased card usage. This cycle made it difficult for competitors to catch up.

By the mid-1960s, the BankAmericard program was generating solid profits. However, Depression-era bank laws forbade banks from having out-of-state customers, limiting the BankAmericard's use to California. To grow the card program beyond their home state, Bank of America decided in 1966 to franchise the BankAmericard to select banks worldwide, charging a $25,000 entry fee and a 0.5% royalty on cardholder spend. In return, Bank of America would teach the smaller banks how to run a credit card operation. The program expanded merchants' customer base and provided customers with broader card acceptance. In short, the program enabled merchants and customers to have different banks for the first time. Now, a customer from Albany could use their BankAmericard to buy from a merchant in Hawaii. But almost as soon as it launched, the licensing program began to fall apart.

The first problem was “authorization”, which verifies if a customer’s card is valid and if they’re within their credit limit. This process is straightforward if both the merchant and customer use the same bank; the merchant calls their bank, which checks the customer's account. However, with different banks, it became complex.

The merchant would call their bank, which then contacted the customer’s bank, often putting everyone on hold. The customer and merchant would wait in the store for a response. Delays were common, especially if the customer’s bank was on the East Coast and the transaction occurred late in California. If communication failed, the merchant faced the dilemma of accepting the card or losing the sale. If the card turned out to be stolen, disputes arose over who should cover the losses.

The second problem was “interchange”. A functional interchange system is crucial for nationwide credit card operations. Since most transactions involve two banks—a merchant's bank and the card issuer—there must be a system to settle their accounts with each other. For example, if a Bank of New York cardholder made a purchase at a merchant affiliated with Bank of Hawaii, Bank of Hawaii needed a way to be reimbursed by Bank of New York.

Both authorization and interchange may not sound like a big deal, but remember, this was before computers were widely used.

Thus, to settle accounts, the merchant bank had to physically mail crates of paper and sales receipts to customer banks across the country almost daily. The cardholder banks then had to manually match sales drafts with customer accounts, reimburse the merchant bank, and finally bill the cardholders. Handling settlements with 150 banks, millions of cardholders, and billions of dollars without computers was daunting. Transactions piled up, customers went unbilled, and balancing issues were frequent.

Bank of America developed their credit card to simplify lending operations, but ironically, licensing the BankAmericard led to its own accounting headaches.

Faced with mounting paperwork and financial losses, the licensee banks threatened to abandon the BankAmericard system. In October 1968, Bank of America called a meeting with all of them in Columbus, Ohio, to resolve the issues. After a tense discussion, Bank of America agreed to spin off the BankAmericard program into a separate entity co-owned by all the member banks, called National BankAmericard Inc (NBI). While the banks continued to compete for merchants and cardholders, they agreed to cooperate at the system level by setting operational standards, developing infrastructure, sharing advertising costs, and building technology.

NBI quickly got to work and used computers to digitize the processes. By 1973, NBI had automated the authorization process, followed by interchange automation in 1976. This digitization allowed for 24/7/365 transaction processing, reduced authorization times from 5 minutes to 50 seconds, enabled overnight transaction clearing, and cut postage and labor costs by $17 million ($79 million today) in the first year alone.

Once the system was stabilized, National BankAmericard Inc. opted for a rebrand and chose the name Visa, becoming an independent organization. Visa then began expanding geographically under the names Visa Canada, Visa USA, and Visa Western Europe. Later in 2007, during its IPO restructuring, all these entities were merged into a single company called Visa Inc. Consequently, Visa went public in 2008.

Today, Visa sits at the center of more than half of the world's credit card transactions, connecting cardholders (and their banks) on one side, with merchants (and their banks) on the other. Because there are thousands of banks, millions of merchants, and billions of consumers, it would be far too complex for every entity to have a direct relationship with every other entity. So Visa acts as a centralized operator, developing technology, maintaining infrastructure, and setting operating standards for all parties.

References: