What Is a Credit Card and How Does It Work?

Most people believe that the concept of the credit card is straightforward: People deposit their US dollars in banks. Banks then offer credit cards. They give you a credit card and a limit as to how much you’re allowed to spend. Then, when you swipe the credit card, the bank covers your purchase by handing out the US dollars that their customers deposit and later on, you pay the bank back plus interest. Simple.

No, it’s not that simple. In fact, credit cards do not work that way at all. To understand how credit cards work requires a fundamental grasp of banking operations. Now, I know some of you are thinking, “God, boring lecture ahead.” Not really. In fact, you might find it quite interesting, or possibly even shocking. While it is a complex concept, I will endeavor to keep things as simple as possible. That means I’ll give you a basic overview, which is quite enough and it’s really all you will need to understand.

The Bank Determines Your Creditworthiness

Each bank has its own standards for what it considers “creditworthy”. One bank might offer many different types of credit cards: a basic card, cash back cards, travel rewards, etc., and each card will have a different standard to qualify for it. Generally speaking, most banks first consider your credit score. There are many different types of credit scores, but the most popular is FICO, so we will use it as the example. FICO ranges from 300 – 850. The bank sets the minimum score allowed for its credit card and won’t consider anything less at that point in time. Economic conditions affect the standard. In a booming economy, banks might relax their standards of what constitutes “creditworthy” and so, lower the minimum FICO score necessary to qualify. In a recession, banks will tighten what constitutes “creditworthy” and raise the minimum FICO score. Let’s assume two banks and two different credit cards.

Capital One offers the Quicksilver card and Chase offers the Slate card. To qualify for the Quicksilver card, Capital One might require a minimum score of, say, 620 and for the Slate card, Chase might require a minimum of 650. Let us assume that you do not think that you will qualify for the Slate card, so you choose to apply for the Quicksilver card. You apply and after checking your credit and other information on your application, Capital One approves you for the Quicksilver card with a credit limit of $1,000. Congratulations! Your card arrives in a week or so and you’re ready to buy some things. Now, at this point you might be saying, “You’re not telling me what I don’t already know.” True enough, but it is at the point of making a purchase with the card that what you “think you know” goes out the window.

Your Credit Limit Isn’t Actual US Dollars

You might think that you have a credit limit of $1,000, but you do not. What you actually have is a Quicksilver card with a credit limit of 1,000 Capital One bank IOUs. That’s right. You are allowed to spend 1,000 Capital One bucks. They aren’t actual US dollars. If you had the Chase Slate card, the limit would be 1,000 Chase bucks. Each bank has its own IOU, just like, say, Publix has a different coupon than Kroger and these bank IOUs are not interchangeable. Capital One will not accept payment in Chase bucks and vice versa. To turn the bank’s IOU into actual “money” that everyone will accept, first something special has to be done to the bank’s IOU.

Denomination

Actual US dollars do not come from banks. They come from the US Government. The US dollar is the US Government’s IOU. Each national government has its own currency that it issues which that particular nation uses. The currency is defined by what is known as the “unit of account”. For instance, in the United Kingdom, the unit of account is the Pound, “£” whereas in the United States, the unit of account is the US Dollar, “$”. Banks do not have the authority to issue US dollars. Only the US Government can do that. So then, if the bank’s IOU isn’t an actual US dollar, why does everyone accept the bank’s IOU? Well, nobody accepts the bank’s IOU as is. They accept the US Government’s IOU and federal taxation is the reason why they accept the US Government’s IOU.
You see, the US Government issues the US dollar and then demands that taxes be paid only in US dollars. That means, the US Government will not accept Chase bucks, gold, silver or British Pounds for tax payments. Only US dollars. By demanding taxes payable only in US dollars, it forces everyone in the United States to get ahold of US dollars. Federal taxation creates a demand for US dollars and hence, it is why we use US dollars. So, the trick for banks is to make their IOU “behave” or “act” like US dollars.

In the United States for instance, banks do this by denominating their IOUs in US dollars. (In the UK, banks denominate their IOUs in British Pounds. In Australia, in Australian dollars.) Doing so makes the bank’s IOU acceptable as payment for goods and services as well as settling tax liabilities to the government and the IOU can then act as “money” in the private sector. In other words, the bank agrees to exchange its IOU for US dollars. Further, banks have what’s known as a reserve account at the Federal Reserve (The Central Bank). This account contains actual US dollars, but the Federal Reserve doesn’t allow banks to lend them out. Those actual US dollars are there for a very special reason.

The Payments System

When you write a check or swipe your debit card to pay for something, that payment must clear. If you have a bank account at Bank of America and I write you a check from my account at Chase, then Chase needs to be able to transfer the funds to you at Bank of America. Bank of America can’t use “Chase bucks”, but what they can use is US dollars. That is what bank reserves are for – To operate this payments system ensuring that payments clear. With this understanding, let’s swipe your new credit card and watch what happens.

You walk into Best Buy and purchase a TV for $800. We will assume that Best Buy has a bank account with Chase. You swipe your card at checkout and the purchase is approved. Excellent. You go home with a new TV. Behind the scenes, your credit limit now drops by 800 and $800 actual US dollars transfer from Capital One’s reserve account held at the Federal Reserve to Chase’s reserve account held at the Federal Reserve. Capital One’s reserve account drops by $800 and Chase’s rises by $800. Best Buy’s account increases by the number 800, reflecting the reserves transferred. In short, bank IOUs are being traded in the private sector while the actual US dollars just shift back and forth between accounts held at the Federal Reserve, never entering the economy. The $800 payment for the TV cleared.

Now, does this mean that Capital One is short $800 in reserves? Not necessarily. You see, Capital One is also receiving payments too. Someone is paying their credit card bill or depositing money in their Capital One 360 account and so, reserves are shifting from other banks’ reserve accounts held at the Federal Reserve to Capital One’s. The key thing to note here is that in no way, shape, or form do the amount of reserves that Capital One has on deposit at the Federal Reserve determine Capital One’s lending capacity. Capital One will lend regardless of how many reserves it has and later, if it finds itself short of reserves, it will seek to obtain more. How?

There are three ways outside of enticing new customers to open accounts and make deposits:

1. Capital One can obtain reserves from other banks
2. Capital One can sell bonds to the Federal Reserve in exchange for reserves
3. Capital One can borrow reserves at the Federal Reserve’s discount window

Let’s assume that Capital One is short of reserves. Capital One will always seek the cheapest route as the more reserves cost Capital One, the less Capital One makes on its loans. Rather than using the discount window, Capital One will try to obtain reserves in the Fed Funds market. This is the market where banks with excess reserves will lend to banks that are deficient. However, please note that interbank lending of reserves does not increase the amount of reserves in the banking system. US dollars are still just shifting between reserve accounts. Now then, what if the entire banking system as a whole is short of reserves?

If Capital One has any bonds, it can sell them to the Federal Reserve and the Federal Reserve will create US dollars out of thin air and deposit those dollars in Capital One’s reserve account. If not, then Capital One will visit the Fed’s expensive discount window and get the reserves. And again, why is Capital One doing this? Because the payments system must operate. Payments must clear. Bank reserves are not there so banks can lend them out. They are there so that when you buy a TV, the business or person you bought it from can get their payment. Finally, let’s look at what happens when you pay off the $800 TV purchase.

Let’s say you have an account at Chase. Now then, you pay off your $800 credit card bill at Capital One. The reserves held at Chase’s reserve account at the Fed shift to Capital One’s reserve account, your bank account at Chase drops by 800 and when you check your credit limit at Capital One, you notice that it has risen by 800. The original 800 Capital One IOUs that Capital One lent you are now destroyed. Your $800 payment has cleared. End of transaction. The actual US dollars that everyone thinks were lent out, were not. They remain safe and sound at the Federal Reserve.
The only thing ever lent out was a bunch of bank IOUs that were acting as “money” in the private sector.