Stay, Fold or Draw: Banks Ponder Their Moves in the Credit Card Fame

By Jerry D. Craft

Credit card portfolios no longer provide sure-fire earnings for regional banks. To stay in the game, banks need creative approaches that lower overhead and risks.

Profits are just not in the cards anymore. That's what many regional bank CEOs are concluding about their credit card portfolios. Alarmed by rising delinquencies and declining profitability, some strategists already have thrown up their hands, selling off all or parts of their portfolios. Many others have throttled back severely on growth. Banc One Corp.'s recent decision to acquire First USA Inc. is another indication of the fundamental changes occurring in the card arena.

Suddenly, after decades of profitable expansion, bank cards are hitting a wall. Driven by a nationwide surge in household bankruptcies, losses are estimated to have exceeded 5% of average outstanding balances in 1996-more than 100 basis points higher than the year before. Combined with rising marketing expenses, credit reversals sharply impacted profitability, which fell to a pre-tax return on assets of roughly 2.5%-down 50 basis points. A further decline in pre-tax ROA is anticipated this year.

Along with this cyclical dip in profitability, regional issuers face a long-term competitive threat that may be even harder to overcome. The four public credit card companies-MBNA Corp., Advanta Corp., Capital One Financial Corp., and First USA-continue to wield their marketing, financial and technological advantages to devastating effect.

These "category killers" are picking off the best customers from the multitude of regional banks preoccupied with a host of other operating and strategic issues. In a scant three years, in fact, the four issuers doubled their share of domestic Visa and MasterCard balances to 24%. And more sharks are invading the waters, as evidenced by the forthcoming debuts of Providian Bancorp and Metris Cos., both monoline card companies.

The Banc One/First USA deal underscores the trend towards specialization. Rather than absorb First USA's card program, Banc One intends to merge its own $12 billion card portfolio into First USA's $22 billion operation. The net effect is that First USA will manage $35 billion of outstandings as a separate company, making it the nation's third largest card issuer. This can be taken as a strong indication that Banc One has concluded the monoline approach works better.

Clearly, this is a time of decision for players in the middle and lower echelons of the credit card industry. Some banks should exit the business. Many other institutions have compelling reasons to stay in the game. But survivors will have to dig deep, mustering advanced skills in marketing, technology, efficiency and risk management. Creative alliances will also grow in importance, with a wide assortment of financial services players pooling resources to do battle with the giants of the industry.

In the long term, economies of scale are essential to survival, and a significant industry shakeout can be expected as small-scale players bow to the inevitable. But by no means should all contestants scurry to the exits. Banks leaving the card business are severing a critical link to the payments system, a move that could damage long-term competitiveness. Given the rising popularity of remote banking, few institutions want to confine themselves to the shrinking end of the financial services playing field occupied by cash, checks and other paper-based instruments.

Though the card business is under duress, requirements to stay in the game aren't as onerous as some might think. As a rough rule of thumb, remaining in the business makes sense if a bank holds at least a 5% share of card loans in its home territory. And not all the environmental factors are gloomy. Cards have plenty of potential to wrest additional volume from cash and checks, which still carry four times as many transactions.

But continuing to play the game in the old way is probably not a viable option. Regional banks need to think creatively about how they can lower marketing and operational costs of card programs while focusing on what they do best-which is lending. Such a streamlined, focused approach offers at least one promising way to compete with monoline issuers and larger banks.

Alliances can help.

Companies both outside and inside banking are available to handle various aspects of credit card portfolio operations, in arrangements that leave the regional bank in control of customer relationships. Such partnerships are already well-established on the merchant side of the business. They are springing up on the consumer side as well, with last year's joint venture between Barnett Banks Inc. and Household Credit Services Inc. being a prime example.

Potential partners could include consumer service providers such as utility, cable and Internet companies, as well as firms that provide portfolio management and marketing services. Such partnerships would allow members to share strategies and expenses for marketing, retention, service delivery, risk management and technology.

To be sure, alliances run the risk of splintering on the shoals of differing visions and agendas. Partners face constant struggles to stay focused on mutually-agreed-upon plans in rapidly changing markets. Those unions losing sight of the bottom line and failing to roll with market changes will be short-lived. The objective should be creating long-term value, not a quick fix. And the alliance must be mutually beneficial. If the distribution of profits favors one side at the expense of the other, the venture could quickly unravel.

But the risks and effort seem well justified, given the alternatives banks face. The experience of the last few years demonstrates clearly that traditional bank card operations are in decline. Thus, the real question is whether to jump ship or steer a new course.

Category Killers

Rising marketing costs point up the problems faced by issuers. Because most creditworthy consumers already possess several credit cards, response rates to mail solicitations are down. To avoid portfolio shrinkage, in turn, issuers must either: 1) Retain and activate more existing customers; or 2) Cut pricing and/or add features; or 3) Lower account approval standards; or 4) Try some combination of these approaches. But there's a downside. All of these courses of action carry the risk of higher loan losses and lower profitability. Why? They tend to attract weaker or less profitable credits into portfolios.

At the risk of stating the obvious, issuers would be well advised to avoid weaker credits right now. Owing to the well-publicized surge in bankruptcies nationwide, delinquency and loss rates have been rising for the last two years. There is a real danger that the expanded availability of credit, combined with increased consumer debt levels and liberalized bankruptcy rules, may lead to a structurally (which is to say permanently) higher level of losses in the industry.

Wresting market share from competitors, another means of spurring growth, will be difficult for most regional banks, given the dominance of the four public credit card companies and the money center banks. The top 10 issuers now control 62% of total domestic card receivables.

Even the largest banks are having trouble holding their own. Among the top 12 card issuers, there are only four bank names-Citicorp, Chase Manhattan Corp., First Chicago/NBD Corp. and Banc One. And the market share controlled by these four banks declined 5 percentage points to 22% between 1991 and 1995. Meanwhile, the other eight players-which include the four public monoline companies plus Dean Witter, Discover & Co., AT&T Universal Card, Household and American Express Co.-saw their combined share surge by more than 13 percentage points, to 30%. Banc One's link up with First USA might be properly understood as a tactic along the lines of, "If you can't beat 'em, buy 'em."

While the category killers do face tremendous pressure to sustain loan growth and earnings momentum, their hard-won portfolio growth yields handsome rewards-additional fee income; market share gains; lower loss ratios (since their marketing savvy lets them zero in on the best customers); and the potential for favorable scale economies. The monoline issuers also enjoy a hidden advantage. Because they securitize their loans, they do not generally fund an allowance for credit losses above actual losses-as do issuers holding card assets on balance sheets. This frees up additional dollars for already-generous marketing budgets.

Such single-minded focus gives these companies the marketing and technology leverage to identify, reach and recruit the cream of the consumer crop. And that's what it takes to succeed in today's saturated card market.

Regional banks, by contrast, must devote significant attention to other pressing issues, including whether they should be acquiring other banks or will be targeted themselves. Bulging with diverse products and services, banks resemble department stores trying to compete with specialty superstores. Not surprisingly, the specialty players perform more nimbly on their home turf.

Protecting Customer Relationships

Of course, many bank card strategists already realize that the stakes have been raised and new approaches are required. But what should they do? Still viewing credit cards as a core product that supports customer relationships, they are afraid to tamper with their programs.

But rather than regarding customer relationships as something fragile that should not be disturbed, banks should view them as a strong foundation to be built upon. Relationships may provide the very element that keeps regional banks in the credit card game. Regional banks offer customers something they want but can't always get elsewhere-name recognition, trust, and a local history and/or presence. Consumers generally prefer to look locally first-and especially to their own bank-for the services they need.

One reason banks have lost credit card market share is their failure to capitalize on this preference. While it's true that the "Visa" or "MasterCard" brand name is more recognizable than the bank's own name on a card, banks have failed to leverage the potential strength of their co-brands, particularly in home markets. At a time when the average consumer holds five cards, he or she needs a reason to choose the local bank's brand. And local banks can supply this reason, positioning the card as part of an entire financial services relationship. Consumers know their local bank better and would even feel an obligation to pay its credit card bill before that of any other issuer.

The swift advent of electronic banking may give local banks an additional edge. Consumers are confused by unrelenting technological advances, deregulation, and government mandates that require use of electronic funds transfer for most government payments beginning in 1999. A growing number of financial transactions are now executed via computer screens and chips on a stored value card, as opposed to face-to-face interactions with a banker in a branch. Customers who don't like these impersonal changes are more likely to turn to their familiar local bank, and they are less likely to respond to a mail solicitation from some out-of-state company they've never heard of.

Market share, however, is important in capitalizing on the hometown advantage. A regional bank that lacks at least a 5% share of credit card loans in its home territories cannot be considered a significant player and should re-evaluate its credit and payment card strategy.

Credit card market share should also be compared with checking account penetration. The checking account is a key determinant in banking relationships. If credit card market share lags checking account market share, the bank should be concerned about losing customers to card competitors offering additional financial services.

Credit cards have long been the worldwide currency of choice and convenience. They promise to become even more enmeshed in the fabric of the payment system as Internet and smart card commerce expands. The bank card issuers that emerge successfully from the current environment will be those that stop viewing the credit card as simply a lending tool and recognize it as a key payment instrument of the future. The true dilemma facing regional banks is not a short-term question about whether to continue in the credit card business. Rather, it's a long-term question of what position they want-or need to have-in the evolving electronic payment system. Are banks willing to let nonbanks take over credit cards, which constitute a key link to this system?

AT&T Corp.'s experience helps illustrate the point. AT&T's Universal Card program recently became unprofitable. But it still provides a powerful entree to the payments system and access to millions of customers to whom the telecommunications giant can offer other services. Put another way, AT&T has built a second relationship with millions of current customers who view AT&T not only as a telephone utility, but also as a financial and payment services provider. We can expect more nonbank companies to emulate this strategy. Banks that give up their place at the payment system table will be opening their customers' wallets to nonbank issuers, who will extract more than just credit card business.

Staying in the Game

For all of its challenges, the card is a progressive financial instrument. Banks that turn their backs on it and other new media confine themselves to a small and shrinking end of the financial services playing field occupied only by cash, checks and other paper-based instruments. By limiting their involvement with the payment system, issuers could find themselves out of the loop when future services are developed, thereby missing out on growth opportunities. And tortoise-like postures will enhance the potential success of competitors' predatory initiatives. Consolidations such as Banc One and First USA should serve to underscore the need for action.

Bank card issuers opting to stay the course face the decision of whether to go it alone or seek out partners. Going it alone will be a formidable task requiring a sizable investment. The current environment for financial services discourages flying solo unless an institution is already among the market leaders. Such a bank must already have broad market impact backed up by ongoing investments in people, marketing and technology.

Partnerships represent a more viable option for banks that lack commanding market share.

The precedent already exists on the merchant processing side of the business, led by giant First Data Corp. and its various arrangements with issuers. Other partnerships materialized last year in joint ventures between Visa USA and TSYS (Vital Processing Services), and between MasterCard International Inc. and National Data Corp. (Global Payment Systems).

On the consumer side, credit unions have always outsourced most of their card processing and servicing, while banks are just beginning to awaken to the opportunities. In the alliance between Barnett Banks and Household, announced in October 1996, the two companies will jointly manage the bank's $1 billion receivables portfolio in Florida and Georgia. The agreement also calls for Barnett and Household to market cards under the Barnett name. Other banks, such as First American Corp. of Nashville and Connecticut's Webster Financial Corp., have outsourced their bank card portfolio management and marketing operations.

The Banc One/First USA combination may propel the next generation of partnerships. The potential synergies are indeed impressive. First USA contributes a wide array of credit card products, vast database capabilities, marketing expertise and a proven management team. Banc One, in addition to a sizable credit card program of its own, provides a large customer base, a distribution network and financial resources. The obvious intent is to leverage these complementary factors into a bona fide national financial services platform.

In a further step, bank card issuers could team up with other consumer service providers, such as utility, cable and Internet companies. These companies need access to the payment system to meet the needs of their customers but don't want to be lenders themselves. One might view an alliance of this type as taking co-branding to the next level by bundling it with multiple products. Such partnerships would allow members to share strategies and costs for marketing, retention, service delivery, risk management and technology-based solutions to common problems.

Companies that provide consumers with financial services, information, communications services and entertainment options are now tripping over themselves in an effort to reach the same market independently. It is clear that the stage is being set for a new approach to serving this market in a way that will cut overlapping efforts and attendant waste. For example, it can now cost upwards of $300 in marketing expense for three companies to sign up the same consumer for their different lines of business-$100 apiece for the credit card issuer, long-distance provider, and Internet access provider. If these three companies were to combine their efforts, marketing expenses could be halved.

While such partnerships would differ in detail from each other, their success will likely depend on one common element: each side sticking to its core business and expertise. The financial institution, for example, should make its profit from credit card lending, not from long-distance call volume or Internet access. Simply put, a partner should not expect its core business to be propped up by another partner's core business.

With the right partners, proper financial structure, and an equitable division of cost, risk, and reward, regional banks can develop alternatives to exiting the credit card business. The profits are still there. It's just a matter of developing new methods for capturing them.

Mr. Craft is president and chief executive officer of Card Issuer Program Management Corp., an Atlanta-based consulting firm.

Copyright © 2003 by Banking Strategies, published by BAI.

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