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Risk and return in the credit card industry

Jamal Munshi, Sonoma State University, 1999

All rights reserved

The nature of market forces and competition

The heartless 19th century Darwinian view of capitalism described by Herbert

Spencer, that undesirable social effects constituted the price of progress, has given
way to regulatory mechanisms designed to mitigate them and to build a kinder
gentler capitalism. The Sherman Anti-Trust Act of 1890, the formation of the SEC,
the FDIC, and the Federal Reserve and enactment of the slew of laws following the
1930s depression to regulate the financial industry were intended to moderate
volatility and attrition problems.

Regulation Q is a good example. Banks operate by holding high interest assets and
low interest liabilities. They profit from the spread. The spread also absorbs interest
rate volatility. Regulators believe that a contributing factor to the financial meltdown
of 1929 was the unrealistically thin spread brought about by intense and
uncontrolled competition among banks. Regulation Q effectively sets a minimum to
the spread. It is, as are all such regulations, "anti competition". We adopt such
regulations because we believe that the net long term benefit to the society and to
the economy is positive.

This sort of relationship between competition and volatility may be viewed as a risk-
return metric. In perfect and efficient markets expected returns from risky assets
are related to the risk of holding those assets. Risk is defined as the uncertainty in
the returns projection. The CAPM (capital asset pricing model) (Sharpe 1964)
describes such a relationship. The CAPM, though controversial (Fama French 1992)
is nevertheless accepted as mainstream financial theory today (Munshi, 1994). It
states that in an efficient market higher expected returns can only be achieved at a
higher risk and that the economy at any time establishes a consensus price of risk
through its market mechanism.

When competition is fierce, it forces some firms into dangerous waters to "bottom
fish" in a high risk regime. In this state, the economy or the industry appears to be
healthy but is metastable in the sense that a small external shock can cause severe
attrition because of the amount of risk that has been taken. In this paper I argue,
using various measures of risk, that the credit card industry was in in such a state
in 1998.
The architecture of the credit card industry

The credit card industry was born in the 1960s. Credit card banks, that is, banks
that exist primarily to issue credit cards, and non-bank issuers were an innovation
of the '80s. The current architecture of the credit card industry evolved when the
Bank of America renamed its "Bank Americard" as "Visa" and invented the payment

A simplified model of this architecture is shown in Figure 1. The payment network is

the glue that binds the system together. The major firms in this arena are Visa,
Mastercard, American Express, and Dean Witter. (American Express and Dean
Witter are also issuers). The payment network maintains a merchant base which
consists of merchants who accept the card and to whom the network forwards
prompt payment when a cardholder makes a purchase. The network charges the
merchant a fee of approximately 2% of the sale for this service. This fee is the
primary source of revenue for the network and the "merchant acquirers" who
manage the merchant base.

The network also maintains "member financial institutions" who are banks that
issue the network's credit card. The banks in turn "solicit" and build up a customer
base of cardholders who will use their credit cards to make purchases from the
merchant base and to obtain cash advances. The bank borrows funds from the
money market and other sources and pays for the purchase at time t and then
collects from the cardholder at time t+n days where n is typically between 30 and
120. The assets of the credit card issuer consist of the accumulated debt of the
cardholders to the bank. The liability side consists of loans it took from the money
market to pay the network for the purchase. It profits from a spread in the effective
interest rate between the asset and liability sides and from seasoning its assets.
Seasoning refers to maintaining a high value of n. It may also generate revenue by
charging various types of fees such as annual fees, late fees, cash advance fees, and
over-the-limit fees.

A more complete picture of the bank's cash flows is depicted in Figure 2. The spread
that the bank actually earns is significantly reduced by charge-offs and back office
expenses. The management of these expenses, particularly charge-offs, is the crucial
factor in credit card bank management in a competitive environment. A spread of
7% can rapidly diminish to less than 2% with charge-offs in the 4% range. In a
highly competitive arena, back office costs arise solely from origination and
Spread management

The gross spread of the banker is the difference between the interest charged on
loans and the cost of debt that supports these loans. Figure 18 shows the trend in
these rates. In 1996 the average industry rates were: credit card rate = 15.5%, cost
of funds = 5.2%, leaving a gross margin of 10.3%. Yet the net margin earned by
commercial banks that participated in a Federal Reserve Survey showed net margins
of 2.14% in 1996. Record bank earnings of $14.8 billion in 3Q 1997 came from
revenue increases in spite of shrinking net spreads and falling "efficiency ratios"
(Figure 12). The net spread represents a difference between two large and variable
numbers and is therefore more variable than either of these numbers in terms of
changes expressed as a percentage.

Several variables ar responsible for the erosion of the gross margin. The most
important of these is the charge-off rate. It represents the percentage of the
outstanding debt that will not be collected due to bankruptcy (about 50%), fraud, or
other reasons. Historically the charge-off has been around 3% for credit card users.
Since 1992 the charge-off rate and the rate of personal bankruptcies have been
rising during a time of sustained economic growth, in what appears to be a paradox.
At the end of 1997 credit card outstandings stood at $450 billion and the charge-off
rate at around the 5% mark. By Feb 1998, the charge-off rate had risen to 6% with
some banks reporting 8%.

Another source of margin erosion is the convenience user. Most credit card terms
and conditions allow for a "grace period" before interest is charged on purchases.
There is normally no grace period for cash advances. The grace period requires the
issuer, in essence, to make an interest free float of up to 45 days on average to the
cardholder. Some cardholders take advantage of this float and pay off the entire bill
within the due date and do not carry a balance. Issuers whose revenues are
generated mostly by interest are vulnerable to this behavior because they rely on
seasoned balances for their income.

The "convenience user" rate has risen from 10% in 1990 to over 31% in 1997 (Figure
11). Figure 17 show how a 31% convenience user rate can reduce a 13% gross
margin to 1% under certain conditions. Securitization raises the effective rate of
convenience users since the securitized portion is free of grace period float. The
managed portion must absorb all the grace period costs.

Back office costs include solicitation costs, credit check and scoring costs, and
collection costs. Competition has forced all of these costs to go up as bankers send
out more solicitation letters (2.8 billion in 1997) and reach into riskier demographics
for new accounts. These accounts necessarily require better and costlier screening
and also increase collection costs.
On the portion of the portfolio that is securitized, the bank incurs origination and
"convenience user" float costs but saves on collection costs and may be able to earn
a 1% spread. On its own managed portfolio, it may struggle to break even with
chareoffs and back office costs.

In such cases the issuer must rely on fee income for revenue. Annual fees are
contentious and a hard sell with consumers who hold multiple cards. Currently
there are over 120 million cardholders in America with an average of 4 cards per
cardholder. Event fees have become popular to circumvent the annual fee problem.
Events that generate fees may include delinquency, cash advance, and going over
the limit.

Generating interest income from a credit card portfolio requires the bank manager to
play a dangerous game of "chicken" with the consumers and their credit scores. The
bank wants the consumer to carry a balance for as long as possible but not so long
that it increases the probability of default beyond a given threshold. The banker's
seasoning dilemma is shown graphically in Figure 3. The optimal seasoning lies at
the intersection of the two curves but since the impact of seasoning on default is not
known very well conservative bankers will stay well behind it but cut-throat
competition is leaving some banks with few options but to extend their seasoning
policy to higher risk levels.

Credit risk management

Low profile but watershed innovations are changing the consumer credit industry in
fundamental ways (Derivatives Strategy 1998a). These innovations include scoring,
convergence, and credit derivatives.

Pressed by competition to hold near-default assets in their portfolio, bankers can no

longer rely on conventional credit ratings and have therefore resorted to costly
models that use a technique called "credit scoring". Scoring models use
classification and regression techniques to identify variables that differ significantly
between defaulters and non-defaulters and to identify the predictors of default.
Scoring costs significantly reduce the already thin margin of issuers even though
their classification accuracy is uncertain especially when projected to economic
conditions that might destabilize the underlying regression models.

The term "convergence" refers to the growth of securitization of bank loans.

Securitized credit card debt has grown from zero to over $ 220 billion in 1997
(Figure 15). By then about half of the credit card debt was securitized (Figure 9).
Some banks have securitized more than two-thirds of their credit card portfolio
(Capital One 1998). In a typical deal an investment banker will underwrite $100
million in credit card receivables at a discount and create asset backed securities
(ABS) against the projected cash flows. These securities are then floated and traded
in fixed income securities markets and rated by by rating firms such as Fitch to
compensate for low trading volume1. Securitization allows bank managers to remove
selected segments of their credit card portfolio from the books and to generate cash
flow when it is needed; and it narrows the distinction between the bond market and
the bank loan market.

Banks also use swaps and other derivatives to manage the credit risk of their
portfolios. The size of this market exceeded $50 billion by the end of 1997
(Derivatives Strategy 1998b). In addition to vanilla fixed for variable asset swaps and
total return swaps, banks also use innovations called "credit default swaps" and
"credit spread options". They are used to carve out the credit risk portion of an ABS
and sell it separately to a contra-party who wishes to take the risk. The derivative
market is an arena for trading risk that can be contractually separated from the
underlying asset.

Revolving credit data from the Federal Reserve's G19 report (FRB 1998) shows the
innovation and rapid growth of securitized revolving credit. The rate of transfer of
the outstandings from bank balance sheets to securitized debt slowed between 1992
and 1994, the profitable years, but has accelerated since then (Figure 9).

Competition in the credit card industry

Competition between issuers of credit cards reduces their margins by increasing

solicitation and scoring costs on the one hand and simultaneously increasing the
charge-off rate and decreasing revenues on the other side of the spread. The squeeze
on the spread is exacerbated by competition motivated priorities such as low
introductory rates, balance transfer, and low or absent annual fees.

It is difficult to maintain both market share and spread; and in their attempt to do
so the banks have incrementally increased the complexity of the fee structure. In
addition to annual fees, the fee structure may contain different kinds of fees such as
over-the-limit fee, late payment fee, cash advance fees, and other fees that may be
imposed under certain conditions. The interest portion may include low introductory
rates, punitive rates under certain conditions, varying grace periods, and variable
rates with floors but no caps. The complexity and variety of credit card terms and
conditions confuse consumers and they complicate cash flow and spread
management by bank managers and the securitization market.

1 In deep and liquid markets all available information is quickly incorporated into market price but in thinly traded
securities traders do not have access to this kind of information and have come to rely on research forms to generate
proxy market information. This dynamic has given rise to the securities rating industry.
The rapid growth in credit card debt since the end of the 1990 contraction (Figure
16) actually understates the impact on household debt because of the "home equity
loan" (HEL) innovation and its derivative called the "125% LTV". Credit card debt
that has been "consolidated" with HEL no longer show up as consumer loans but as
home loans although they have not gone into increasing the value of homes. The
market for HEL is nearing saturation possibly because of this reason and also
because it has been very actively marketed by banks as a tax shield and debt

The 125LTV innovation essentially extends the HEL market to 125% of the current
assessed market value of the home. Some firms such as Fidelity First Financial
Corporation have targeted the 125LTV market as a credit card consolidation
program and others such as ContiAsset have started a program of issuing credit
cards against a pre-approved HEL or 125LTV (American Banker 1998). ContiAsset
was formed by parent HEL specialist ContiFinancial. The 125LTV portfolio grew from
$3 billion in 1996 to over $10 billion in 1997. A successful LTV125 marketing
program will increase household debt levels which in turn will increase the number
of defaults for a given rate of economic slowdown should it occur.

The use of low interest introductory rates and low balance transfer rates has
significantly reduced the industry's interest earnings. The introductory rates are
typically 5% or 6% while the normal rates are in the 16 to 20% range. In a balance
transfer, one bank cannibalizes a performing seasoned account of another. Each
such transfer reduces the net profitability of the industry as a whole.

Chargeoff, bankruptcy, and "competition risk"

In his study of consumer debt Garner (1998) found that the effect of rising consumer
debt on the economy is uncertain because the available data do not have a clear
interpretation and because recent changes in the financial industry makes it
difficult to determine the relationship between economic growth and consumer debt.
He concludes that the rise in consumer debt is not sufficient predictor of a recession
especially in light of healthy growth in employment, disposable income, and savings.
Although the correlation between personal bankruptcies and consumer loan defaults
is intuitive and empirically validated (Bishop 1998, FRB 1997), the direction of the
causality is not clear and is possibly complex. In most analyses (Bishop 1998)
bankruptcy is treated as a purely exogenous process that generates charge-offs.
However, the data (Figure 5) are also consistent with the competition theory of
bankruptcy proposed in this paper and conceptualized as follows;

Competition can force issuers who have access to scoring and other
techniques, to seek out marginal consumers who will carry a balance. This
process itself can generate the observed coincident rise of charge-offs and
bankruptcies. The rise in bankruptcies is not a simple exogenous process but
one that is created, at least partially, by the competition strategies of credit
card issuers.


Consumer debt both as credit card debt and as home equity loans used to
consolidate credit card bills, has doubled since the 1990 contraction during a period
of sustained growth in GDP and employment. Simultaneously, personal
bankruptcies and credit card charge-off rates have also risen to record levels amid
intense competition among hundreds of credit card issuers. The thin spreads of
issuers and high leverage of consumers creates a metastable system which will be
unable to sustain even a small economic downturn without significant volatility,
attrition, and social cost.

The social cost of competition extends beyond attrition. In the competitive arena,
banks are targeting low income families, Hispanics, and the elderly with home
equity. The increasing number of convenience users who tend to be on the upper
layers of the income distribution remove wealth from because they benefit from the
float. A segment of low income households may "benefit" from the charge-offs by
going into default. These "benefits" do not come at the cost of the banks who are
already operating on thin margins but at the cost of the hard working, perhaps
mostly low income families, unable to pay off their credit card debt and making
payments on several thousand dollars per family of high interest credit card debt.

The confusing pricing structure of credit cards is the result of competition. It is

confusing to consumers and perhaps even to the bankers themselves who are
uncertain of the revenue and spread dynamics of portfolios consisting of myriads of
pricing structures. Perhaps consolidation and structural changes in the credit card
industry will help to alleviate the social cost of competition and nurture a kinder
gentler capitalism.
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Figure 1: Architecture

Figure 2: Issuer cash flows

Figure 3 Seasoning credit card debts

Figure 4 Delinquency data

Figure 5 Charge-off and Bankruptcy trends

Figure 6 GDP Data

Figure 7 Bankruptcy trends

Figure 8 Bankruptcy and GDP

Figure 9 Growth of securitized revolving credit

Figure 10 Credit card fraud trends

Figure 11 Convenience user trends

Figure 12 Quarterly income of commercial banks

Figure 13 Bank efficiency ratios

Figure 14 Net margins of commercial banks

Figure 15 Securitization trends

Figure 17 Growth in revolving consumer credit

Figure 18 Average gross credit card spread