Global Card Issuers Undergoing Deleveraging
By Park Sang-soon
Senior Partner, BCG Seoul Office
The global credit card industry is facing a myriad of challenges in the wake of the global financial crisis. In the post-crisis world, plastic issuers both at home and abroad are urged to tackle several issues.
First of all, the global credit card industry is under pressure to improve its fundamentals since the financial crisis. As the global financial crisis exposed household over-indebtedness, concerns have been raised in the U.S. and elsewhere that a second subprime-type meltdown could originate from the credit card industry.
Such concerns have materialized to a certain extent particularly in the U.S., where the financial crisis spilled over into the real economy, raising unemployment levels, which are consequently damaging credit card businesses. Moody's credit card charge-off rate, for instance, hit a record 11.49 percent in August 2009.
Having been hit by unprecedented levels of delinquencies, credit card issuers around the world are focusing on deleveraging and de-risking their balance sheets as a first step toward improving their fundamentals. In other words, they are reorienting their businesses toward low-risk activities such as credit sales as opposed to loans for financially sound customers.
Since the crisis exposed the risks of an over-reliance on wholesale funding, a greater emphasis is being placed on attracting and retaining a sustainable deposit base. In the process, U.S. monoline card issuers in particular are switching to bank holding companies or acquiring banks in a bid to stabilize their funding base with retail deposits. AMEX and Discovery, for example, switched to bank holding companies in the second half of 2008; Capital One acquired Chevi Chase that same year.
Korean monoline issuers after the nationwide credit card distress in 2003 seem to be on the road to acquiring a strong long-term funding base that is relatively immune to fluctuations in the financial market. Funding by corporate bond issuance or long-term borrowing, which accounted for 20 to 30 percent of total funding before the credit card distress, now accounts for over half of total funding.
As lower risk-taking in the asset side leads to deteriorating profitability, while intensifying competition for deposits in the liability side leads to higher funding costs, risk management capabilities and operational efficiency will gain renewed importance as sources of competitive advantage.
Increased Focus on Risk Management
Second, the emphasis on risk management is increasing. Card issuers seeking to bolster their balance sheets will be forced to become more selective over who they lend to, which makes accurate risk assessment critically important. As such, banks will seek to upgrade people and infrastructure in their risk management functions. Their redesigned organizational structures must place risk management at the center.
Risk-based pricing will have greater value when founded on such accurate risk assessment. When moving into riskier businesses serving riskier customer segments, issuers will need to accurately reflect expected losses and capital requirements in their pricing in order to defend their margins; furthermore, they will need to ensure that excessive risk-taking is discouraged through a voluntary and self-regulating mechanism.
Capital and reserve requirements for unused credit limits, in particular, will compel issuers to review their capability to manage credit limits as more than simply a means of risk management but rather a crucial component of profitability.
Third, operational excellence will determine issuers' profitability. As issuers shift their focus from loans to credit sales, profitability will be squeezed more and more. Credit sales not only offer slimmer margins than loans, they will demand greater marketing costs as competition intensifies.
Therefore, strategic cost reduction will be emphasized. Few players have a thorough understanding of their cost base and allocations. And most banks will need to significantly reduce their cost base.
To that end, a strategic approach will be required to ensure cuts do not put revenues at risk.
In implementing strategic cost reduction, priority must go to enhancing the cost-effectiveness of marketing - the single largest cost item. Methods are being introduced that measure the cost-effectiveness of every marketing initiative and allocate marketing budgets based on such measurements.
Fourth, responding to tougher regulations to protect credit card users. In the aftermath of the financial crisis, US issuers took actions to defend profitability by charging higher interest rates and cutting back on a number of customer services. Some even raised the interest rates they charge to members who defaulted on payments owed to other issuers from 7 to 8 percent to more than 20 percent.
Against such background, the U.S. Congress among others came out denouncing card issuers for overcharging taxpayers after having been rescued with taxpayer money, raising concerns that such extortionist practices would worsen the economy by putting further strains on household finances. Thereafter, "The Credit Card Accountability, Responsibility and Disclosure Act" was signed into law in May 2009.
That piece of legislation prohibits arbitrary revolving rate increases; prohibits rate hikes within one year of opening an account except upon expiration of a term for which a given rate applies, or when floating interest rates apply, or when a card holder is more than 30 days late on a payment; permits revolving rate increases one year after opening an account on the condition that the card holder be notified 45 days in advance.
A similar shift in the regulatory environment is also taking place in Korea, heralding a general improvement in the protection of consumer rights. Card issuers, however, will likely find their margins further squeezed as a result.
Need for Innovation
Finally, the credit card industry needs innovation. The developments in the competitive environment we have seen so far will pose a considerable challenge to the credit card industry. For mature markets like Korea, the key challenge is finding a new growth engine in an environment set to become more and more competitive and less and less profitable.
New technologies, combined with the current pressures on profitability will serve as a catalyst for change and innovation in the credit card industry.
Credit card issuers will need to diversify their revenue and reduce reliance on conventional sources such as interest income and merchant fee. In the medium to longer term, the industry will seek to reposition the credit card business model to drive more income from usage, by providing increasingly innovative ways such as contactless cards and mobile payments for customers to make payments.