Recent trends in the profitability of credit card banks

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Andrea Meyercord

CREDIT card lending has traditionally been a highly profitable line of business for banks. Increased competitive pressures in recent years, however, have prompted many card issuers to reduce interest rates, lower or waive annual membership fees, provide program enhancements, and offer rebate programs to make their plans more attractive. Despite these developments, the profitability of "credit card banks," or banks specializing in credit card operations,(1) not only remains high relative to the rest of the banking industry but also continues to grow.

This article analyzes recent trends in credit card bank profitability and the factors underlying them. Evaluating the trends only in the aggregate, however, would ignore some interesting differences in profitability between two distinct groups of institutions. The first group consists of credit card banks owned by bank holding companies (BHCs), a relatively well-established market segment. The second group comprises credit card banks owned by nonbank firms, a more recent and fast-growing component of the credit card market.

The article finds that despite growing competition from nonbank-owned credit card issuers, the return on assets of the more "traditional" issuers--those owned by BHCs--increased significantly over 1992-93 and continues to exceed that of nonbank-owned credit card banks. BHC-owned institutions have proved more profitable than their nonbank-owned counterparts largely because better asset quality trends in recent years have enabled them to maintain a lower level of provisions for loan losses.

AGGREGATE PROFITABILITY TRENDS OF CREDIT CARD BANKS

The profitability of credit card banks can be measured as an average annual return on assets. Chart 1 traces the weighted average return on assets over the years 1989 to 1994 for all credit card banks with total assets of $200 million or more.(2) The data through 1993 measure the returns as of year-end; the 1994 return is estimated by annualizing first-quarter figures. The chart shows that the average return on assets for credit card banks has been relatively high over the years examined. As a point of contrast, whereas the average return for credit card banks ranged from 1.9 percent to 3.4 percent during the 1989-93 period, all other U.S. commercial banks within the same asset size category had an average return on assets ranging from 0.4 percent to 1.1 percent in the same period.

Chart 1 also reveals that the average return on assets for credit card banks has been steadily increasing since 1991. This rising trend in profitability is particularly notable given that the spread between card issuers' lending rates and their funding costs has been shrinking since early 1992. Comparing the average credit card rate of U.S. card issuers(3) with the one-year Treasury note rate--a conservative benchmark for issuers' cost of funds--indicates that, overall, issuers' margins decreased from 14.1 percent in February 1992 to 12.7 percent in February 1994. Although both lending rates and funding costs fell over this period, the decline in lending rates exceeded the decline in funding costs, resulting in a contraction in the overall funding margin.

PROFITABILITY AT BHC-OWNED AND NONBANK-OWNED CREDIT CARD BANKS

The aggregate trends presented in Chart 1 conceal some notable differences between the levels of profitability exhibited by BHC-owned credit card banks and those observed for nonbank-owned credit card banks. Such differences are of particular interest since these two groups are direct competitors in the credit card business.

Increased competition from nonbank-owned issuers is a recent and important development in the credit card market. Although the Bank Holding Company Act of 1956 prohibited nonbank companies from owning banks, in the early 1980s several nonfinancial firms found that they could conduct credit card business by acquiring so-called nonbank banks. Since nonbank banks limit their operations to either deposit taking or lending, they did not legally meet the Bank Holding Company Act's definition of a "bank" as an institution that engages in both activities, and thus were not subject to the act's restrictions on bank ownership. The Competitive Equality Banking Act of 1987 addressed this exception by amending the definition of a "bank" and banning new nonbank bank charters. However, the 1987 act exempted credit card banks and a few other special purpose banks from the new definition of a "bank." Thus, since 1987, the number of nonbank-owned commercial banks that specialize in credit card lending has surged.(4)

Over the past few years, nonbank-owned issuers have gained substantial market share at the expense of more traditional BHC-owned issuers. Among the top twenty-five credit card issuers (ranked on the basis of total credit card loans outstanding at the credit card subsidiaries of BHCs, thrifts, and nonbank diversified financial services companies), the share of outstandings held by nonbank-owned issuers grew from approximately 24 percent in 1991 to 37 percent in 1993 (Chart 2). In part, this trend reflects the recent entry into the credit card market of firms like AT&T, General Electric Capital Corporation, First USA, ADVANTA Corporation, and Ford Motor Company. The number of such nonbank-owned institutions figuring among the twenty-five largest issuers rose significantly around this time, increasing from five in 1990 to ten in 1993. In addition to making entry-related gains, nonbank-owned issuers have also captured market share through increased lending, both by originating credit card loans themselves and by acquiring the credit card portfolios of other issuers.