Developments in the pricing of credit card services

Federal Reserve Bulletin, Sept, 1992 by Glenn B. Canner, Charles A. Luckett, Wayne C. Cook, Mark A. Peirce

By 1984, the profitability of credit cards had risen above that of most other forms of lending, and it remained relatively high through the end of the decade. This rather long period of high profits raises the question of why competition did not at some point exert heavier downward pressure on credit card rates. One possible answer is that, as banks broadened the market by distributing cards to individuals of lower creditworthiness, a larger risk premium was incorporated into the rate structure, tending to keep rates up. The persistently high credit card interest rates in the latter half of the 1980s may have reflected anticipation of higher credit losses, but the unusually long economic expansion postponed the realization of those expected losses. (16)

CREDIT CARD PROFITABILITY

Data on the performance of credit card operations suggest that higher levels of credit card delinquency and default have raised the costs of credit card operations in recent quarters. A reduction in the cost of funds during the same period, however, has largely offset the losses, helping to maintain relatively strong earnings for the industry as a whole.

Table 4 summarizes historical data from the FCA on the net before-tax earnings on credit cards and other types of credit of small and medium-size banks. The table also provides data on credit card profits of large credit card banks compiled from the FFIEC (Federal Financial Institutions Examination Council) Report of Condition and Income.(17) On average, for the period 1974-91, earnings of banks participating in the FCA were slightly lower for credit cards than for other types of credit. For these institutions, credit card earnings were considerably more volatile than earnings on installment or real estate loans (as measured by the standard deviation) and were comparable in volatility to commercial lending. On the whole, earnings on credit cards at these small and medium-size institutions do not appear to have been out of line historically with other lending activities. Credit card earnings did outpace income from other sources over the years 1984 through 1987, but other loan products had similar runs of higher-than-average earnings at other times.

The data for the large credit card banks suggest a somewhat different pattern of recent experience. Compared with the FCA banks, the large credit card banks earned similar or higher returns from 1986 through 1990, but reported earnings dropped below the earnings of FCA banks in 1991. The different experiences of the two groups of card issuers may be related to theft selection of customers. The large credit card banks have typically solicited more marginal credit risks than the smaller institutions. The difference is reflected in the loan loss experience of the two groups. While FCA banks have had annual fraud and credit losses of about 2 percent of outstanding balances during most of the past decade, the large credit card banks have had consistently higher losses, generally between 3 percent and 5 percent of outstanding balances. These differences suggest that the large credit card banks are selecting a different point on the risk-return frontier than their smaller counterparts. Consequently, it would be expected that when the economy is performing well, as it did during the mid-1980s, issuers that bear more risk would outperform more conservative issuers. In weak economic periods, such as the most recent one, however, the performance of large issuers would be expected to suffer from sharply rising credit losses.