Pressure from COVID-19 in the form of aggravated charge-off rates poses the danger of disrupting, to a certain extent, the U.S. credit card business model that has been successful since the '80s, through the recession, until now. Interest margins are favorable, and expenses are under control, but credit card write-offs are on the brink of surging. The industry will need to shift its stance and tighten its focus. The United States is not alone in this risk; it affects every market.
Today U.S. households carry on average four general-purpose credit cards, with 500 million in force in the United States-down from a high of seven in 2008. Automation and technology drive the business, from acquisition and underwriting, to credit management and customer service. While the model has served financial services and consumers well, current economic and employment issues due to COVID-19 have upset the model to the point that issuers must rethink their business proposition.
The Calculus of Credit Card Revenue
Our recent research report on credit card profitability provides a detailed look at credit card revenue dynamics. A significant finding from that report is that the Return on Asset (ROA) metric for top credit card issuers consistently outperforms the same measure for commercial bank lending. In 2014, for example, all commercial banks produced a ROA of 1.23%, while top credit card issuers delivered 4.94%. Bank card performance continued to outpace commercial banks through 2018, the latest numbers reported by the Federal Reserve's Report to Congress on the Profitability of Credit Cards. In that year, all commercial banks achieved a 1.46% ROA, while top credit card issuers delivered 3.79%,
A simplified version of the credit card return on asset (ROA) model begins by determining income, subtracting expenses, then producing a net income figure and comparing it with outstanding receivables. In credit cards, income and expenses classify into two channels, interest income and non-interest income.
Interest income is simple: it is the cost charged to cardholders for the use of extended credit. The most recently published number by the Federal Reserve report indicates the interest rate charged for U.S. credit card use was 11.53%. Interest expenses, the cost of providing those funds, either through balance sheet lending or other funding sources, was 1.82%, yielding net interest income (NII) of 9.71%.
Once net interest income is determined, consider net non-interest (NNI) components. Non-interest revenue includes fees, such as those charged for usage, penalties, and services. From non-interest revenue, subtract expenses, including operating expenses, sales, marketing costs, and infrastructure. According to the latest data available from the Federal Reserve, total non-interest income was 3.78% of total assets, and non-interest expenses were 6.32%. The net result of non-Interest income minus non-Interest expenses was negative 2.54%. In other words, credit card issuers generated net income on interest rate spreads but lost income on their non-interest line items.
At this point, adding a net interest income of 9.71% of portfolio value to non-interest income of -2.54% has an initial pre-write-off yield of 7.17%. However, write-offs also referred to as charge-offs, must reduce income. In the case of 2018, charge-offs were 3.36% of the receivable value, providing credit card issuers with a healthy 3.79% return on assets.
With these items in mind, credit card issuers must be hyper-sensitive to a deterioration in charge-offs, such as those that face the industry today.
The Problem Facing Credit Cards Today is Write-Offs
With record unemployment, and the Organization for Economic Cooperation and Development (OECD) suggesting double-digit unemployment through 2022, it is a fair expectation that charge-offs will begin to surge in late 2020 and continue through the next two years. This write-off will upset the ROA model described above.
Consider the 3.79% return rate resulting from the 3.36% write-off rate. If write-offs surge to 10% as they did during the Great Recession, when unemployment was lower than the OECD prediction, the card business will be in for a shock.
Substituting the 10% write-off rate for the 3.36% charge-off rate from 2018 will invert the profitability model. Instead of producing a 3.79% ROA, the card industry will be in negative territory. The swing might create a negative ROA of over 6%. This danger is global.
Card issuers are better prepared to withstand the shock of high write-offs than they were before Dodd-Frank increased loan loss reserve requirements; stress testing did its job. Still, it will not prevent credit card issuers from losing money over the next two years.
The question now becomes, how should credit card issuers reposition their product to ensure a healthy yield that satisfies bankers, consumers, and shareholders?
Modernizing the Credit Card Model
Consumers have high expectations for rewards, which have a direct effect on net non-interest income. The cashback an issuer might offer often exceeds the interchange generated by the transaction. Similarly, the marginally qualified customer with a 660 FICO Score, might need to tighten balance caps and require higher interest rates to cover the associated risk. The solution might be to consider cardholders as a "profit center of one," rather than a mass-market assessment of account performance.
New Credit Card Accounting Guidelines May Set the Pace
New requirements by the Financial Accounting Standards Board (FASB) on the recognition of credit losses might set the stage for rethinking the credit card business model as a "profit center of one." Under the new model, Current Expected Credit Loss (CECL), credit card issuers must shift from the traditional model of reserving for charge-offs based on historical portfolio performance to an individualized view of account risk. The change is crucial because, instead of looking at the risk of an entire portfolio, credit card issuers must examine risk at the account level.
At the account level optic, credit card issuers have the opportunity to gain a better understanding of account level risk, and with that can make better decisions to maintain or close the account, adjust credit lines, and create forward-looking strategies for account control.
With this in mind, the account level approach to profitability management sets the stage for card issuers to attract deposits, additional products, and, most importantly, contain risk.