Bolstering Credit Card Profitability Despite Challenging Economic Indicators
(New York, NY): It’s been quite a while since the U.S. credit card industry has had to worry about profitability. Nearly a decade of close-to-zero funding cost and below-trend losses were the perfect mix for very healthy margins, even after increasing both consumer rewards and co-brand partner compensation. But lately, new data is emerging that suggests the good times may be waning.
From 2012 to 2016, US credit card issuers experienced a gradual erosion of profitability. Net income as a percentage of average assets fell from a high of 6.6% to 2.7%, according to the FDIC. In this context, the results of the 2017 stress tests, in which credit card assets represented the largest potential credit risk for the large bank holding companies, seems more understandable.
While a net return on assets (ROA) of close to 3% is still a healthy profit margin by banking standards, the downward trend is unmistakable. (It’s particularly noteworthy that this erosion was concurrent with historically low interest rates.) And there are new risks to profitability: data from Auriemma’s Industry Roundtables indicate that the top 11 U.S. card issuers’ average quarterly loss rate increased 13.4% between the fourth quarter of 2016 and the first quarter of 2017, signaling that the increasing credit loss trend has not yet abated.
While these trends are gathering force, it’s important to note that the credit card industry has seen difficult times before and has always been able to adjust and rebound. Here is a potential roadmap for this situation.
The first step for all players, regardless of size, is to conduct a deep-dive portfolio review. By identifying which segments are most vulnerable to deterioration, an issuer can more closely tailor possible solutions. Ideally, the segmentation should be more than just a FICO or risk segmentation and would include profitability metrics as well. While the CARD Act has essentially eliminated the ability to re-price for credit migration, calculating profitability for each FICO band (or other risk metric) is still a critical step in evaluating the portfolio. This analysis can be optimized with segmentation by either origination vintage or by origination campaign. Of particular importance: vintage analysis for any change-in-terms (CIT) portfolio actions. Establishing the link between underwriting changes and credit outcomes is critical to an honest assessment.
After the portfolio review, there are many possible paths to follow. Here are a few strategies for issuers to consider.
Take no action. If the portfolio review suggests that the credit trend is anomalous or is likely to revert to a better level, then taking no action and continuing to monitor the portfolio may be the best course. One month does not a trend make.
Be the counter-puncher – and aim for growth. Being aggressive when others play a conservative hand is a time-honored, but high-risk way to grow. (Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”) Some issuers will see the market deterioration as an opportunity to gain market share as more conservative issuers pull back. This approach is not for the faint of heart, and the challenges it presents are obvious. But for a highly capitalized, sophisticated, credit-savvy issuer this can be a tremendous opportunity.
Change underwriting standards. For an issuer that has seen some portfolio deterioration but is not expecting a default tsunami, reducing credit exposure on newly originated accounts with tightened underwriting may be all that is needed. In addition to modifying credit selection and market solicitation criteria, issuers will also want to revisit line assignments (both for the existing portfolio as well as for the new accounts), collection entrance parameters, servicing and collection strategies among other operating levers.
Conduct a portfolio segment sale. One possible outcome of the portfolio analysis, depending on the issuer’s outlook, may be to sell a segment of the portfolio which effectively transfers a disproportionate share of the total portfolio credit risk. While this type of pruning is not always possible, the current market appetite for consumer credit risk makes this a feasible strategy. (A recent example is Barclaycard US’ reported sale of $1.6 billion worth of subprime credit card receivables to the Credit Shop this year.)
These are just a few of the possible avenues to explore in the current environment. Auriemma has a deep institutional memory about prior challenges and the creative ways in which successful issuers responded.
Ultimately, the strategy selected may be less important than the quality of the portfolio review; a strategy premised on a superficial analysis may be more dependent upon luck than execution. If, after a thorough portfolio review, an institution concludes that no change is needed, that may be a viable choice made with eyes wide open. Heading into a challenging credit environment, however, it’s safe to say that inertia without analysis is hardly a wise choice.
About Auriemma Group
Auriemma is a boutique management consulting firm with specialized focus on the Payments and Lending space. We deliver actionable solutions and insights that add value to our clients’ business activities across a broad set of industry topics and disciplines. For more information, contact John Costa at 212-323-7000.