Credit Card Industry

"Models of Profitability" Project
Jianwei Xu (MSB '02)  April 29, 2002
 

Credit cards provide three major services: means of payment, consumer loans, and product marketing. In the past decade, credit cards’ share of consumer spending had increased from 8% to 14%. By 1999, general-purpose credit cards accounted for 75% of revolving debt.  

According to The Nilson Report, a trade publication that covers the consumer payment systems industry worldwide, general purpose credit and debit cards displaying the brands of Visa, MasterCard, American Express, JCB (JCB International Credit Card Co. Ltd.), and Diners Club generated $3.2 trillion in total transaction volume worldwide in 2000, an increase of more than 21% from 1999. The number of cards outstanding also rose, to 1.36 billion at year-end 2000, up 12% from a year earlier, while the number of transactions generated by these brands rose nearly 18%, year to year, to 38.54 billion.

Visa maintained its leading market position in 2000 based on purchase volume, with a worldwide market share of 57.2% (versus 56.5% in 1999) according to The Nilson Report. MasterCard’s market share in 2000 was 26.4% (26.5% in 1999), American Express’s was 13.3% (13.4%), JCB’s was 1.6% (1.85%), and Diners Club’s was 1.6% (1.8%).

Activity in the United States also rose. The five brands of general purpose credit cards in the United States are Visa, MasterCard, American Express, Discover, and Diners Club. According to The Nilson Report, the number of cards outstanding in the United States at year-end 2000 totaled 673.8 million, up 9.5% from a year earlier. Total transaction volume was $1.56 trillion in 2000, up more than 16%, on a total of 17.56 billion transactions, compared with 15.03 billion in 1999.

In the United States, Visa also is the market leader based on purchase volume, with a 45.4% market share in 2000 (47.1% in 1999), followed by MasterCard with 26.3% (26.0%), American Express with 20.6% (19.9%), Discover with 6.5% (5.8%) and Diners Club with 1.2% (1.2%).

Visa and MasterCard are mutually owned joint venture associations of thousands of individual financial institutions. The associations operate under what is called “duality”; that is, member banks are allowed to issue both Visa and MasterCard branded credit cards. However, each member bank sets its own fees and terms and issues its own cards. The services that Visa and MasterCard provide include national advertising campaigns, the approval of credit card transactions for merchants, and the electronic notification of card usage so banks can charge their customers’ accounts. Visa and MasterCard also develop terminals and technology that process transactions.

Visa and MasterCard forbid banks from issuing rival cards like American Express and Discover. Visa’s by-laws explicitly prohibit U.S. member banks from issuing American Express or Discover cards. Violating this rule results in the expulsion of the member from the Visa organization. MasterCard policy imposes the same penalty on a bank that issues American Express Cards. Admittedly, banks can still choose to offer other cards.

Marketing and Distribution

Because competition among lenders is usually intense, the costs of soliciting new business and retaining existing customers can be substantial. Response rates tend to be low, and competitors often try to lure customers away. A company’s marketing and advertising efforts are often geared toward the specific market segments in which it has expertise or where it provides the most comprehensive selection of products and services at the most competitive prices. In this manner, a firm can maximize available resources in hopes of attracting the greatest number of customers. The main distribution channels used by consumer finance companies are direct mail, telemarketing, branch networks, event marketing, and retail outlets.

• Direct mail Direct mail involves the prescreening of credit rating databases for individuals with favorable credit criteria; they are mailed offers of lending products such as home equity loans or credit cards. These mass mailings are fairly inexpensive, but they also have a pretty low success rate.

• Telemarketing Telemarketing techniques often use the same financial criteria in locating potential lenders, but the process involves a representative calling the prospect directly to offer the financial products. Telemarketing campaigns tend to be more expensive than direct mail campaigns. They are also more successful, and often can be used as an opportunity to reach existing customers to cross-sell ancillary products like insurance.

How to make money:

Even as the economy slowed down, financial services companies were still able to post strong earnings growth. Broadly speaking, most companies racked up year-to-year earnings gains of 10% to 20% in 2000, either meeting or exceeding Wall Street’s profit expectations. Notably, although many firms in the technology sector announced earnings shortfalls for the first quarter of 2001, financial services industries navigated unscathed through that difficult period.

Traditionally, late fees and interest charges are the major revenue sources. But different card issuers use various models to increase revenue:

Customization and Pyramiding

Consumer finance companies have been exceptionally active over the past few years in soliciting credit card accounts. These firms often entice consumers to open an account by offering a low annual financing rate or by waiving annual fees. Or they may offer low introductory rates for up to a year to customers who transfer balances from other credit card companies.

Credit card issuers have also begun to tailor their offerings to individual tastes and spending habits as a means of drawing in new accounts. This can be seen in the onslaught of prestigious gold and platinum cards, which allow higher spending limits and better services.

Before a loan is made, consumer finance companies thoroughly investigate the creditworthiness of the potential customer. The credit extension process tends to be highly automated. Many firms have proprietary credit scoring models used to determine the creditworthiness of applicants.

Companies often work in conjunction with independent credit rating agencies, such as Experian (formerly TRW) or Equifax, which issue reports of borrowers’ credit histories and paying habits. Coupled with other data (such as employment history, income level, value of designated collateral, and current debt servicing requirements) financial services companies use this information to attempt to gauge an individual borrower’s ability and willingness to repay a loan. Firms often employ credit analysts who are able to override decisions made by a company’s scoring system after receiving further information from applicants.

Co-branding and sponsorships

Some credit card issuers have found a unique marketing niche in co-branding their products with major retailers. In a co-branding arrangement between a credit card company and retailer, the retailer’s name and logo appear on the credit card. In such arrangements, credit card companies enjoy additional account and balance growth and the opportunity to market other products to a new set of customers. Retailers find these arrangements advantageous because they can expand their sales by encouraging credit use, while the card issuer handles the payment collection aspects.

Issuers have also developed sponsor relationships with colleges, universities, and professional organizations. The lender provides the funds, typically embossing the logo or insignia of the endorsing organization on the card, while the organization provides the customer list. Card members are thus encouraged to use the card to show support for the endorsing organization, which may receive a small percentage of the sales proceeds charged with the card.

Reward Programs

Many card issuers now offer reward programs, through which purchasers accumulate points that they can redeem for various goods, such as travel benefits or free airfare on major airlines. Issuers devised these programs to encourage loyalty among customers and to boost credit card usage for items that might otherwise have been paid for by cash or check. Programs such as these are increasingly important, as saturation of the credit card market continues to rise. The ability to create a distinct product with unique benefits is paramount. Credit card issuers have to differentiate themselves from competitors. This is particularly the case when consumers have more than a few cards at their disposal.

Securitization

Since about 1994, securitization of finance receivables has become increasingly popular as a financing mechanism. In a securitization transaction, a lender typically pools various finance receivables, structures them as asset-backed securities, and sells them in the public securities market.

The securitization and sale of certain loans, and the use of loans as collateral in asset-backed financing arrangements, are important sources of liquidity for financial services firms. Together with credit syndications and loan sales, securitizations help these companies manage exposures to a single borrower, industry, product type, or other concentration. Securitizations leave net income substantially unchanged because they convert interest income, credit losses, and other expenses into loan servicing fees, while reducing a company’s on–balance-sheet assets. As loan receivables are securitized, the company’s on–balance-sheet funding needs are reduced by the value of loans securitized. The company often continues to service the accounts, for which it receives a fee. Funds received from securitizations sold in the public market are typically invested in money market instruments and investment securities, which are available whenever the company needs to fund loan growth.

During the revolving period of the securitization — which generally ranges from 24 to 108 months — no principal payments are made to the security holders. Payments received on the accounts are used to pay interest to the holders and to purchase new loan receivables generated by the accounts so that the principal dollar amount remains unchanged. Once the revolving period ends, principal payments are allocated for distribution to holders. This fairly recent trend toward securitization has let financial services companies better manage their funding needs. It also reduces their interest rate sensitivity somewhat, as securitized loans are off the balance sheet and don’t affect net interest margin calculations.

Factors affecting profit:

Federal interest rate

Interest rates affect the profitability of both diversified financial services companies and consumer finance companies by impacting the demand for credit, the cost of funds, and charge-offs. In a falling interest rate environment, the cost of borrowing is reduced, so demand for the industry’s products rises. As interest rates fall, the cost of the funds that companies use to make loans also falls and lending spreads tend to widen. Finally, in general, low interest rates fuel economic growth. Economic growth leads to job growth. Lower unemployment rates often tend to result in higher credit quality. When interest rates rise, the opposite occurs. The cost of borrowing rises, so consumers may forego purchases; the cost of funding loans also rises, putting pressure on spreads; and job growth slows, which may ultimately lead to credit quality problems.

Lending rate (APR)

When it comes to setting lending rates, consumer finance companies can afford to be flexible. While funding costs range from 3% to 8%, the rates charged start at about 9% and can go as high as 20% or more. Lending rates offered by consumer finance companies are usually competitive with those offered by banks, as the two often vie for the same customers. However, because some consumer finance companies specialize in one or a few lending segments, they may be more familiar with the associated risks and thus able to offer more attractive lending rates than banks.

The lending rate charged on a loan is determined by factors that affect the loan’s riskiness: the loan’s duration, whether its rate is fixed or variable, whether the loan is secured or unsecured, the life of the item being financed, and the borrower’s creditworthiness.

• Loan duration Other things being equal, loans made on a short-term basis carry lower interest rates because lenders can more reliably gauge economic conditions and their impact on interest rates over a briefer time span. Long-term loans typically carry higher interest rates to cover the greater potential risks associated with the uncertainty of distant future economic events.

• Fixed- or variable-rate The interest rate on a loan can be either fixed or variable. For a fixed-rate loan, the interest rate remains unchanged throughout a loan’s life. For a variable-rate loan, in contrast, the interest rate is adjusted over time as the lender’s costs fluctuate. For lenders, fixed-rate loans are riskier and thus carry higher interest rates at the date of issue, because lenders cannot raise rates when their funding costs rise. Loans made at variable interest rates carry lower interest charges initially because the lender can respond quickly to changing costs in the future.

• Customer credit rating The borrower’s creditworthiness - or record of making timely loan payments - will also affect the interest rate at which a lender is willing to loan money. A good credit history is attractive to financial services companies, which may offer such borrowers reduced interest rates. Borrowers’ income and debt levels also affect the interest rates they are charged. An individual whose debt levels are high as a percentage of income might have trouble repaying a loan or might have been denied credit elsewhere. A person with such a credit history would likely pay higher interest rates to obtain a loan.

Lending spreads

Despite what some people consider high loss trends compared with banks, consumer finance companies tend to have substantial profit margins because of the wide spreads they enjoy on their lending business. Lending spreads can range from 6% to more than 12%. In essence, consumer finance companies either borrow funds from depositors or raise funds in capital markets (using commercial paper, medium-term notes, and long-term debt) at rates ranging from 3% to 8%. They then lend these funds at rates of 9% to 20% or more. In contrast, commercial banks’ interest margins usually range from 3% to 5%. This reflects banks’ wider mix of business and greater proportion of lower-risk commercial and secured residential lending, which produces much lower margins. Although consumer finance companies generally enjoy wide latitude in pricing their products and services, there are limits. Some states, for example, have usury ceilings (a maximum allowable interest rate that financial institutions can charge). In most cases, however, this rate is higher than 20%. In cases where allowed rates do not adequately compensate for the risks involved, financial services companies can elect not to participate - declining credit to individuals or not actively soliciting their business.

Company size

The nature of the financial services industry tends to favor large companies. Larger companies, which typically offer a number of different products, are able to leverage their distribution systems to get the most products to the most people in the most efficient manner. It is also easier for larger companies to leverage their advertising and generate name recognition. Access to low-cost financing can be a key advantage in the financial services businesses, and larger firms may be able to get the financing required to fund their operations at a lower cost than their smaller brethren.

Default and bankruptcy

In the United States, one negative that clouds the industry outlook is the rising number of default and consumer bankruptcies. Default occurs when the borrower has stopped servicing a debt obligation for a certain number of months. The point at which default occurs is generally determined by credit managers once they’ve exhausted all methods of collecting on the obligation. Bankruptcy trends are of the utmost importance for all consumer finance companies and many diversified financial services firms. U.S. bankruptcy filings totaled 366,841 in the first quarter of 2001, compared with 312,335 a year earlier. It is expected that annual bankruptcy filings will reach an all-time high in 2002, reflecting the economic slowdown and high consumer debt levels. In addition to economic growth and the unemployment rate, many other factors contribute to bankruptcies. These factors include declining home values, and inflationary pressures, divorce rates, lack of medical insurance, the relative ease with which individuals can declare bankruptcy, the fairly forgiving bankruptcy laws currently in place, lax underwriting standards being practiced by financial services companies, and the ease with which loans can be obtained.

As with any other cost of doing business, consumer finance companies attempt to minimize their loan losses. Individual companies may set limits on what they perceive as acceptable levels of losses, depending on the type and duration of loans they make and the interest rates they charge. In general, financial services companies that offer financing for a broad range of different products will experience delinquency rates of 3% to 4%. In the home-equity lending segment, however, alarm bells may ring if loss rates exceed 1%. In contrast, companies that specialize in the credit card lending segment may be content with delinquency rates in the 5% to 6% range, as interest rates earned from the rest of the loan portfolio in the aggregate will more than compensate for these higher loss rates.

Delinquencies and charge-offs are generally higher during periods of adverse economic conditions. At such times, financial services companies may limit the number and amount of loans they’re willing to make. They do this by placing stricter standards on credit availability.

But financial services companies are not the only ones that bear the burden of the high bankruptcy rates. As these companies pass through some of the costs of bad debt, consumers pay higher interest rates than they would otherwise. In essence, consumers who pay their bills end up subsidizing the ones who don’t. In addition, marginal borrowers may end up being denied credit, because lenders become more risk-averse in an environment of high bankruptcies.

Recent Developments in Credit Card Industry

Online marketing

The internet is less expensive and more interactive for directing marketing than direct mail and telemarketing. Forrester Research predicted that 15% of new cardholders would be acquired through the Internet by 2003, up from 1% in 1999. With the popularity of online marketing, the cost saving from this will be substantial for some major online card issuers, such as NextCard.

Online services

Most major card issuers already have offered online services such as balance transfer, balance checking, electronic statement, and online payment. With the fast development of the Internet and the growing convenience of the online services, online services would be more attractive to more cardholders, therefore would increase the card issuers’ profitability substantially.   

Potential online substitutes of credit cards

While credit cards are still used in 90% of online transactions, other online payment systems have sprung up, including digital cash, e-wallets, person-to-person payments and virtual escrow. Although the future of these credit card substitutes is uncertain, it could be a major threat to credit card issuers once they are more widely accepted.