In Search of Credit Card Profitability: Finding and Retaining the Most Valuable Bank Card Customers

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1 In Search of Credit Card Profitability: Finding and Retaining the Most Valuable Bank Card Customers Analyst Author: Dennis Moroney Research Director, Bank Cards June 7, 2010 Reference # V63:16K TowerGroup Key Findings Legislative and consumer behavior changes suggesting that a return to profitability is unlikely for the bank card industry in 2010 should signal issuers to reexamine their credit card business model. TowerGroup believes that card issuers must convert from a business model of short-term profit maximization (SPM) to one of customer relationship value (CRV). The new credit card business model would reduce dependence on short-term profits from interest income and fees and create long-term customer relationship value through crossselling. Consumer purchase and payment behavior having changed, credit card issuers must invest time and money to understand how to adjust their products accordingly. TowerGroup expects that consumers will be carrying fewer cards, which will increase competition for the best customers. TowerGroup expects that the cost of replacing a credit card customer will increase because the number of available creditworthy new account prospects will decrease. Report Coverage This TowerGroup Research Note identifies strategies for retaining the most profitable credit card customers. Until 2009, card issuers relied on the account fees paid by customers with large revolving balances in a business model of short-term profit maximization. TowerGroup believes that 2010 will be a year of transition to a new credit card business model to respond to shifts in consumer behavior and comply with enacted legislation. The new model, which TowerGroup dubs "customer relationship value," will require a long-term view of customer profitability emphasizing creditworthiness and revenue derived by cross-selling complementary products and services billed to the credit card account. Introduction A weak economy in 2009 reduced consumer spending in the United States and globally. US bank card volumes decreased over 9%, from $1.4 trillion (USD) in 2008 to $1.2 trillion in Credit card delinquencies and net credit losses (NCL) reached historic levels in Annual return on assets (ROA), a key measure of credit card profitability, plummeted from 2.75% for 2007 to negative 0.29% for Exhibit 1 illustrates the trend in NCL and ROA for US credit card issuers from 2000 through

2 Exhibit 1 US Credit Card Net Charge-offs and Return on Assets Rates ( ) Source: Federal Reserve, TowerGroup The increase in net credit losses and the lower return on assets are a direct effect of the current recession. Bank of America, JPMorgan Chase, and Citigroup credit card businesses each reported significant net income losses for The combined negative income performance for those three institutions caused ROA for the industry to be negative. In 2009, the US Congress passed the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act. TowerGroup believes the legislation will negatively affect future revenue, credit card profits, and the availability of consumer credit unless issuers change their credit card business model from one of short-term profit maximization. Credit Card Business Strategies Must Change Enactment of the CARD Act, which became law in May 2009, changed the business rules that affect credit card customers. TowerGroup believes that card issuers need to modify their business strategies accordingly. The degree of modification will vary by portfolio because no two credit portfolios are exactly alike in size or the location and creditworthiness of their customers. Exhibit 2 provides a timeline of legislative events leading to the passage of the Act, the new business rules, and implementation dates. 2

3 Exhibit 2 Legislative Timeline and Key Provisions of the CARD Act Source: Federal Reserve, TowerGroup, Experian Impacts of CARD Act Implementation and the Recession The CARD Act will reduce and in some instances eliminate sources of revenue that delivered years of bank card profits. The new credit card business model must change to comply with the new regulations and to adapt and respond to the change in consumer purchase and payment behavior. Some of the direct impacts to the existing business models include: Reduced credit card income from interest and fees Credit card interchange income at risk from regulation Consumers' increasing use of pay-now rather than pay-later products Consumer repayment of debt and increased savings The CARD Act reduces interest revenue. Phase 1 and 2 of implementation of the new legislation included the major provisions of the Act. Prior to the CARD Act, and assuming the issuer included a disclosure in the account terms provided to customers, an issuer could retroactively increase an entire credit card account balance without additional notice to the customer. With some exceptions, the CARD Act prohibits such repricing. The change in this billing method will adversely affect future credit card interest revenue. The CARD Act reduces fee income. Fees paid by cardholders are the second largest source of credit card revenue. Generating slightly less than 20% of total credit card revenue in 2009 were 3

4 annual, cash advance, late, and overlimit fees. TowerGroup estimates that the changes required by the CARD Act will reduce annual fee income by over $3.5 billion for the top five credit card issuers. Interchange is under assault. Interchange produced the remaining 10% of bank card revenue in Interchange is the fee paid by merchants to credit card issuers for processing a credit card purchase and for assuming the risk and cost of collecting the purchase amount from the consumer. Interchange has long been an area of dispute between the merchants and the credit card issuers. Recent legislative activity indicates that interchange is the next revenue source the US Congress will address. In May 2010, Senator Richard Durbin introduced an amendment to the financial regulatory reform bill proposed by Senator Christopher Dodd. The amendment would regulate interchange for debit cards, giving the Federal Reserve Board authority to control that fee system. The reform bill is expected to become law by late summer Consumers' repaying debt and increasing savings reduces card revenue. TowerGroup estimates that in 2009, the traditional short-term profit maximization business model produced over 70% of bank card revenue derived from interest from revolving credit card balances. The interest rate amount, the interest rate calculation, and the amount of balance that revolves are the components that determined interest revenue. The recession changed consumer purchase and payment behavior, causing consumers to reduce purchases and revolving balances. The Federal Reserve G-19 report reflects the change in consumer purchase and payment behavior for Revolving balances decreased 12%, on an annualized basis, reducing 2009 bank card profitability. This was the first such decrease in revolving balances in over 10 years. TowerGroup expects the trend in lower revolving balances will continue for the next several years. The CARD Act changed the method for calculating interest. The Card Act as a Catalyst for Change The change to business rules governing interest rates and fees illustrates the need for credit card issuers to modify their business model. Over 90% of industry-wide historic revenue sources interest and fees will be reduced or eliminated, and interchange, the remaining 10%, is at risk by legislative intervention. The CARD Act and the change in consumer purchase and payment behavior alter the way that credit card issuers must manage their portfolios. Issuers must develop new business strategies to compensate for the lost revenue. To do so, they need to identify and retain their most profitable customers. The changes introduced by CARD Act necessitate that issuers change the selection criteria for identifying the most profitable credit card customers. It is for this reason that TowerGroup believes card issuers must convert from the traditional business model, which we call short-term profit maximization (SPM), to a model we dub customer relationship value (CRV). Strategies for Identifying the Most Profitable Customers The CRV Credit Card Business Model A credit card business model based on customer relationship value would significantly reduce the credit card issuer's dependence on interest and fees and instead stress development of the customer relationship. A CRV model requires the issuer to have a customer-centric service culture that is customer friendly and welcoming. Interactions with the customer will be by whichever channels of communication the customer selects, be it telephone, letter, Internet, self-service, or a customer service representative-assisted call. A CRV model also requires the issuer to develop new card products that respond to customers' current desire to reduce their indebtedness and increase the amount they save. Excellent customer service is integral to the model's success. Customer targeting through segmentation increases retention and card usage and thus profitability. Risk-adjusted customer segmentation is necessary to increase the effectiveness of targeting, to make sure the right products are targeted to the right customers. 4

5 Portfolio Profitability and Segmentation The transition from the SPM to the CRV business model will not be easy. The new model will require a longer sales cycle than the old one to achieve maximum business revenue because the source of the revenue is different. The CRV model relies on increasing the number of financial products the customer purchases from the institution or an alliance partner such as an insurance or travel company. In addition, the model attempts to increase and concentrate use of the card for other purchases. Ideally, the latter is at the expense of a competitor's card or an alternative payment method such as debit, cash, or checks. To achieve maximum CRV revenue will be difficult because consumers currently hold, on average, over five cards and use them interchangeably. US credit card issuers reacted to the recession and restrictions imposed by the CARD Act by reducing the amount of available credit by over $1.3 trillion from the 2008 peak. TowerGroup believes that enhancements in mobile payment technology at the point of sale will reduce the number of credit cards in the typical wallet. Exhibit 3 tracks the decrease in unused ("open-to-buy") credit lines for banks regulated by the Federal Deposit Insurance Corporation (FDIC). The chart includes TowerGroup's projections for open-to-buy credit lines through Exhibit 3 Unused (Open-to-Buy) Credit Card Lines in the US Credit Card Industry ( P) Source: Federal Deposit Insurance Corporation, TowerGroup 5

6 Improving Portfolio Profitability Through New Ranking Models There are no hard and fast rules for segmenting the portfolio, but a good first step is to rank the customers from most to least profitable. Keep in mind that although a short-term profit-maximization model and a customer relationship value model may reflect similar ROA values, the composition of the revenue differs. The SPM model typically skews to a concentration of less creditworthy customers because of their revolving behavior and payment behavior resulting in fees. The analysis in this calculation should identify the source and percentage of revenue (i.e., interest, fees, and interchange and other fee products such as insurance or travel products). TowerGroup expects that interest revenue and fee revenue will decline in the future as a result of both the CARD Act and changes in consumer purchase and payment behavior. The acquisition cost of a new credit card account ranges from $150 to $200, and there is no guarantee the account will be profitable. TowerGroup expects that the cost of replacing a credit card customer will increase because the number of available creditworthy new account prospects will decrease. This is the direct result of more stringent credit standards to avoid charge-offs and the general decrease in consumer demand for additional credit. Calculate profitability. The components for calculating profitability of an SPM and a CRV credit card account are the same. However, the risk of credit loss is typically higher for the SPM model because of account purchase and payment behavior. Profit is the sum of account revenues (interest, fees, and interchange) and fee products (insurance, travel, buying services) minus the cost of servicing, credit losses, and funding. Each component of the account profit and loss (P&L) is important, but the cost of funds and the access to capital is the least understood and a critical component of the account P&L statement. Financial Accounting Standards Board changes altering asset securitization (FASB 166 and 167) have reduced favorable terms for issuers securing capital. The current low interest rate environment has benefited the banks and enabled them to use alternative funding sources. As the economy improves, rates will increase, which will have a long-term negative effect on the credit card business. TowerGroup believes that limited access to capital will benefit portfolios that utilize the CRV model because they will be more stable with fewer risky accounts and lower balance and account attrition (see TowerGroup Research Note V53:32K, Asset Securitization: An Important Tool for Managing the Credit Card P&L). Avoid too-early risk segmentation. Risk segmentation too early in the analysis reduces business opportunity. Risk analysis is an essential step for determining the most profitable customers and is completed as part of the profitability analysis. Institutions vary in their analysis of risk based on their tolerance for credit losses. For some institutions, the risk analysis may be the first step in the segmentation process; for others, it is integrated later in the decisioning process. TowerGroup believes that because customers' individual risk profiles can deteriorate or improve over time, excluding accounts too early in the process may exclude business opportunities. Risk assessments are best determined as close as possible to the date of the extension of credit or a marketing offer. The CARD Act requires the issuer to determine the customer's ability to repay, which is also best calculated when the offer of credit is extended so the determination is based on the most current customer information. Use tools to complement custom and generic credit scores. The segmentation process requires that a hierarchical risk ranking be calculated because profitable accounts do not share an equal probability of going to charge-off. TowerGroup believes the credit bureau scores provided by Experian, Equifax, and TransUnion combined with issuer custom scores are effective tools for ranking the portfolio segments. However, a word of caution is in order: The CARD Act and the recession having altered historic payment and purchase patterns, scores used in the past must be updated and revalidated to confirm their predictive accuracy. Because this process can take months, issuers have become risk adverse and limit their account retention and marketing focus to the best score segments. There are alternatives to this conservative approach. One is testing and 6

7 targeting; another is effective portfolio benchmarking. Testing and targeting. The Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices reveals that the majority of credit card issuers have significantly tightened their credit polices since the recession began in late A small number of issuers, not named by the Federal Reserve, have continued to selectively market to existing customers and/or solicit new customers during the recession. TowerGroup research indicates that these institutions have expanded their use of account attributes for selecting consumers for marketing promotions and have increased the amount of credit information required in the new customer application process. These issuers are testing the expanded use of credit attributes in conjunction with credit bureau and custom scores to identify creditworthy consumers in credit-risky score ranges and to exclude high-risk consumers in creditworthy scores ranges. For example, consumers in creditworthy score ranges with recent and significant increases in credit inquiries may be seeking additional credit because they know they may be losing their job. These consumers may represent a higher credit risk not yet reflected in their credit bureau or custom score and perhaps should be avoided. Testing and tracking the information will answer this question. A second example is testing and targeting consumers in higher-risk score segments. In the past and because of their credit scores, issuers would exclude this group of consumers as too risky. TowerGroup research reveals that issuers are using account attributes to assist them to target worthy prospects in this subsegment. On a small scale, issuers are selectively offering credit line increases and/or new offers of credit to consumers who are in higher-risk score bands. Their credit attributes indicate they have reduced their credit line utilization, and/or their credit profile reflects a lower percentage of recent trade inquiries and fewer recently opened trade lines compared to their peer group. This group of consumers appears to be successfully managing their debt. Testing and targeting will confirm that theory. The benefit of such testing and developing of new account targeting techniques is the head start the institution will have over the competition once the recovery begins. The credit card issuers that use this approach will be rewarded by additional market share and knowledge from the lessons learned in the process. TowerGroup suggests that institutions that intend to reenter the market consider implementing a test and control marketing process now that will help validate their existing risk and profitability scores and provide valuable insights for the future. Effective portfolio benchmarking. Benchmarking the portfolio through regression testing enables the issuer to match and compare historic performance of a segment of consumers against a larger group of similar consumers within the credit bureau files. The analysis compares the performance of the two groups from a designated date in the past to the current day. By highlighting differences between the two groups, benchmarking may identify both risks and opportunities in the way the card issuer has structured its customer segments or determined risk cut-off scores. New rules that affect risk. The rules and criteria governing risk assessment have changed. For example, debit card use has increased and consumers are saving more and reducing their household debt. The real estate downturn has created a new business challenge. An increasing number of consumers are choosing to default on their mortgages because the home's value is less than the mortgage amount owed. Aside from this decision, these "strategic defaulters" may be considered good credit risks. Undoubtedly, such customers are part of every credit card portfolio and, depending on the particular institution's credit policies, the issuer may decide to include them as credit card customers to be retained or exclude them. To maximize the business opportunity, a significant change in credit risk score should be investigated to determine if there are unique circumstances for the deterioration. 7

8 Portfolio segmentation. The risk of the marketing segment ultimately determines if the segment will be profitable. The SPM model migrated from years of profitability to unprofitabilty in 2009 because of high credit losses. The final step after ranking profitability and risk is to segment the accounts into marketing groups. The assignment typically begins at a very general and macro level for example, by distinguishing transactors (those customers who pay their entire balance each month) from revolvers (those who do not pay their entire balance each month). From the baselines of profitability, risk, transactors, and revolvers, the number of permutations and combinations seems almost infinite. It is limited only by the skills, technology, and expense budget of the issuer. Typical market segments will include account attributes such as spending habits, brand preference or affinity, and life-cycle rewards. A basic limitation for segmentation is that a segment must be large enough for development and implementation of actionable marketing strategies to be cost effective. Each institution must make this determination for itself. Recommendations TowerGroup believes that a transition in business models from short-term profit maximization to a model based on customer relationship value is a market mandate for credit card issuers, at least in the United States. Despite the potential difficulties of the transition, TowerGroup believes the realities of the consumer market, combined with the current political climate, necessitate the change. Credit card issuers must comply with the new US consumer legislation, the final phases taking effect in August The Durbin amendment to the financial regulatory reform bill, which affects debit interchange, is a signal that credit card interchange is also at risk. Issuers have a choice to adapt their business models to these changes or to consider exiting the credit card business. Consumers' increased use of pay-now debit products, repayment of debt, and increased savings rates will continue until they feel confident the economy is improving. An improving economy will increase the demand for credit, but the CARD Act and a lower expected ROA for the industry will keep credit tight and available only to the most creditworthy. Deploying a customer relationship value, or CRV, credit card business model will enable the credit card issuer to optimize its portfolio for profitability in difficult economic and political times. Once economic trends improve and the political winds begin blowing in a different direction, the CRV model can be adjusted to accommodate the altered market conditions. Summary Dependence on interest and fees is no longer a successful model for long-term business success in the credit card industry. Credit card issuers must shift to a new business model based on providing long-term value and superior customer service to their customers. The Credit Card Accountability, Responsibility, and Disclosure (CARD) Act and the recession have changed the credit card industry as well as consumer behavior, and credit card issuers must adjust their business strategies to respond. TowerGroup believes that consumer credit will continue to be limited to the most creditworthy and be more expensive to the consumer. As a result, consumers will be carrying fewer cards and competition for the best and most profitable customers will increase. 8