I understand Visa and MasterCard make money on transaction fees, but how much (if any) of those fees do banks see? Do banks make money on people who pay their bills on time, or are reward programs paid for by the people who don't?
There are 3 entities in a credit card transaction;
Typically when you swipe for 100, the merchant only gets around 97.5. The 2.5 is divided amongst the 3 entities, roughly around 0.5 for the Merchant Bank, around 0.5 for the Card Network and a lions share to Acquiring Bank of around 1.5
The reason Acquiring Bank gets large share is they are the one’s that take the risk and also provide the credit to customer. Typically the Acquiring Bank would pay the Merchant bank via the Card Network the money in couple of days. So the Merchant Bank is not out of funds.
The Acquiring Bank on the other hand would have given you a credit of say 10 to 50 days depending on when you made the transaction and when the payment is due. On an average 30 days of credit. So roughly the Acquiring Bank is lending money at the rate of 18%.
It is from this money the Acquiring Bank would give out rewards, which is typically less than 1%.
Also in cases where say Merchant Bank and the Acquiring Bank are same, Bank would make money on both the legs of transaction and hence launch co-branded cards with better rewards.
The above numbers are illustrative and actual practices vary from Bank to Bank to card Network to Country
Related question at How do credit card companies make profit?
One reason why some merchants in the US don't accept Discover is that the fee the store is charged is higher than the average.
Generally a portion of transaction fee for the network and the issuing bank goes to the rewards program. In some cases a portion of the interest can also be used to fund these programs. Some cards will give you more points when you carry a balance from one month to the next. Therefore encouraging consumers to have interest charges. This portion of the program will be funded from the interest charges.
Some rewards are almost always redeemed: cash once the amount of charges gets above a minimum threshold. Some are almost never redeemed: miles with high requirements and tough blackout periods.
Credit cards that don't understand how their customers will use their cards can run into problems. If they offer a great rewards program that encourages use, but pays too high a percentage of points earned can lead to problems. This is especially true when a great percentage of users pay in full each month. This hurt Citibank in the 1990's. They had a card with no annual fee forever, and a very high percentage never had to pay interest. People flocked to the card, and kept it as an emergency card, because they knew it would never have a annual fee.
The banks don't have to pay for credit card rewards. The merchants end up footing the bill.
The merchants that accept credit cards pay from 2-4% in fees on the credit card purchase. Those fees go to support the rewards programs.
The merchants also take on most of the risk during a credit card transaction (although the credit card companies would have you believe otherwise). If a thief uses a stolen card to purchase a camera from Mike's Camera Shop for instance, any funds the merchant received will be taken away from the merchant. In addition, the merchant will be hit with a chargeback fee (usually around $20-$60). Finally, since the card was stolen, the merchant will never get their merchandise returned, so Mike's Camera is out the camera as well. No camera, no funds, and a $60 fee to boot. The credit card issuers make $60 on the chargeback fees and have no liability.