By David Cox, Jean-Yves Gueguen and Brian Shniderman

The fortunes of the credit card industry have changed dramatically. In just the last two years, credit cards have gone from being one of the most profitable areas of lending to one of the least. Record levels of defaults and stalled securitization markets have rapidly reversed the profitability of the industry. The nine consecutive monthly declines in revolving credit from October 2008 to June 2009 represent the longest pullback since this data began being tracked by the Federal Reserve Board in January 1968¹.

The card industry is caught in a perfect storm. Record charge-offs are occurring at a time of increased government regulation. Some estimates suggest that the long-established relationship between credit card loss rates and unemployment levels may be breaking down and that charge-off rates could soon surpass unemployment levels². One issuer has suggested that the days of credit cards as a profitable standalone product are over³.

This brings sharply into focus the debate about the future of the industry, which is currently split between more diversified banks and monoline issuers. The market appears to be swinging in favor of the banks, with their broader funding base, diversified operating platforms, and broader customer relationships. Yet recent reported results suggest that some banks are performing much worse than many monolines, raising further questions about where the industry is headed⁴.

It is likely that all issuers may need to consider a portfolio of options, innovating in some areas while pulling back in others. This will create the need for a more flexible operating model: one that can respond quickly to changing customer needs and compliance responsibilities, as well as variations in transaction volumes and more flexible merchant relationships. For some issuers, a new operating model, rather than an amended one, may be needed.

A Fresh Approach to Merchant Relations

The current debate over interchange fees has reinforced the opportunity for a fresh approach to merchant relations. Issuers should consider proactively partnering with retailers to look for additional ways of adding value to their relationships. This could be a win-win situation for all involved and would tie interchange fees more closely to retailers' top and bottom lines.

Nearly one in 10 consumers chooses their credit cards based on rewards that are funded by merchants and can be redeemed where consumers shop most frequently⁵. Many of the shopping habits and expectations that consumers developed online can now be shaped for traditional Brick and Mortar environments. For maximum effectiveness, such discounts should be carefully targeted, marketed electronically, and redeemable automatically since an all-electronic approach can drive greater repeat usage than the in-statement marketing that has traditionally predominated⁶. By partnering with merchants, issuers can not only increase merchant activity, but also make their cards more attractive to existing and potential customers.

A Shifting Payment Landscape

Are credit cards a standalone product or part of a diversified range of financial services? Seen as part of the payment family of products, credit cards can be viewed within the context of the evolution of payment services. (See Exhibit 1)

Exhibit 1 also illustrates how the drivers of value in the payment industry have changed over the years. It is also interesting to note that the rise of credit cards coincided with a significant drop in the U.S. savings rate, a trend which has now begun to reverse. It is still too early to say whether this will be sustained. However, the growth of online retailing and alternative payment mechanisms, such as PayPal and Bill Me Later, each of which have amassed a significant number of merchant relationships, all point to a new generation of payment services.

One option for issuers is the development of credit cards as a general eCommerce solution providing consumers with the ability to research products online or through social networking sites, offering discounts for targeted merchants and a range of settlement options.

Another option might be for credit card issuers to become a multi-purpose instrument with debit and credit features, with both physical and online capabilities. Consumers could make online purchases using the online version of their credit card services without having to reveal their account number to the World Wide Web.

In some parts of Europe and Japan, even mobile phones are being used as payment devices. These have a prepaid amount stored on a chip with the phone used in the same way as a contactless payment card relying on near-field communication technology. The concept of a credit card and the form it might take are likely to change significantly over time.

There are significant opportunities for developing the card product in addition to rewards, personalization, and pricing structures. Whether through the traditional payment or credit line functionalities or as a broader banking and deposit tool, issuers should consider a clear product development path to forestall disruption and address some of the current industry challenges.

The New Paradigm of Risk Management

Twenty years ago, the credit card industry was primarily a short-term lending business. Subsequently, issuers determined that the biggest profits didn't come from people who repaid their balances regularly, but from customers who maintained a constant level of debt. As a result, consumer loans became a perpetual earning asset⁷. This created a substantial revenue stream from interest rates and fees on late payments and credit limits that had been exceeded. Today, Americans have an average of 5.3 all-purpose cards in their wallet and the average household has $10,679 in consumer debt⁸.

However, a business model which relies on continual borrowings creates significant risk management issues during difficult economic times. Issuers may wish to consider incenting borrowers to repay balances with lower interest rates. This could enhance customer experience, broaden card acceptability and potentially reduce risk as well. It would also bring issuers more in line with regulatory guidance⁹.

A renewed focus on default management has now become a critical success factor for the industry. (See Exhibit 2) It may also provide a more effective mechanism for compliance management.

By segmenting customers into different loss probability buckets and prospects for collectability, it becomes easier to develop collection strategies based on where customers appear on the matrix, their psychographic score detailing their behavior, profile and characteristics. An emphasis on performing standard and routine processes efficiently and effectively is paramount to success in addition to compliance with recent government legislation (CARD Act) and other regulations (e.g., Fair Lending).

A More Flexible and Agile Approach to Operations

The need for innovation challenges all issuers to adopt a more flexible approach across a number of areas:

• Technology platforms – Issuers may wish to consider the extent to which they can deploy new technology to improve efficiency and increase flexibility. Issuers with strong technology platforms and flexible operating models may wish to consider offering their processing capabilities to other providers or seek alliances in processing, competing more in service delivery and customer experience.
  
• Leveraging merchant relationships – Bank issuers in particular may wish to consider the extent to which they can leverage their broader retail relationships to expand their merchant networks or alternatively redefine the merchant relationship in the context of a broader banking relationship. By packaging interchange fees with other service fees, bank issuers may be able to get an increased share of the customer's wallet, while merchants may be able to negotiate reduced interchange fees.
  
• Exploiting opportunities in recession – Changing patterns of consumer behavior create opportunities as well as threats. Targeting special programs with discount retailers may be an opportunity to improve merchant relations and drive increased card usage. Advertising sales opportunities on more discretionary items presents another opportunity. Additionally, to the extent that card issuers can diversify revenue streams through innovation and additional product opportunities, they may reduce the impact of a lower level of economic activity.
  
• Legislative pressure on fees and rates – Pressures here will force issuers to revisit business and operating models, perhaps radically. Getting to the heart of regulatory concerns about product and pricing transparency, and the clarity and comprehensiveness of customer communications, may be a way to reduce a potentially rising tide of regulatory attention.

Uncharted Waters

As issuers face unprecedented market challenges, the temptation may be to adopt a more conservative stance. But the more successful companies in this industry are likely to be those that can convert the current challenges into opportunities through innovation, while cutting back in those areas which are no longer profitable or may expose the issuer to undue risk.

It is important to distinguish between current market challenges and longer-term shifts within the industry. The former may be passing phases while the latter are transformational. The growth of Internet commerce and online retailing are examples of transformational themes that the industry must adapt to.

This is not a time for marginal adjustments. For many issuers, a paradigm shift may be required. Some issuers may reinvent credit card services within a broader range of payment or other financial services through a more diversified approach. Others may adopt a single product approach, but excel in customer segmentation, risk management and operations.

Although the current challenges may seem forbidding, they represent important opportunities. Reconnecting with customers and merchants provides issuers with the chance to move from adversarial relationships to "win-win" partnerships. Innovating across a number of key dimensions may create opportunities for enhanced performance without increasing product complexity.

About the Authors

David Cox is the director of research at the Deloitte Center for Banking Solutions. In this role, he is charged with the development of thought leadership initiatives in the banking and securities industries, coordinating various research efforts and helping to differentiate Deloitte more effectively in the marketplace.

Jean-Yves Gueguen is a director of the financial services practice at the Deloitte Center for Banking Solutions. With a focus on strategy and operations and as both a consultant and a company executive, Jean-Yves has spent more than 25 years driving change and improving performance at large financial institutions.

Brian Shniderman is the director of financial services, banking and payments at the Deloitte Center for Banking Solutions. Brian leads initiatives to gather unique payments data from primary research on consumer and merchant behaviors, as well as payments-specific cost reduction techniques.

1 Jeremy M. Simon, "Consumer Credit Card Balances Plummet" CreditCards.com, August 7th, 2009
2 Patrick Jenkins, Francesco Guerrera, and Saskia Scholtes, "How the Cards are Cut", The Financial Times, July 27, 2009
3 "JP Morgan CEO Jamie Dimon Sounds Off on the Future of Credit Cards," Seeking Alpha, July 17, 2009.
4 Matt Phillips , "Credit Card Update: Bank of America Leads in Default Rate Rise" The Wall Street Journal, June 16, 2009
5 Edward Koontz, "What U.S. Consumers Care About When Choosing a Credit Card", Forrester Research, July 16, 2009
6 Edward Koontz, "What U.S. Consumers Care About When Choosing a Credit Card", Forrester Research, July 16, 2009
7 Remarks by Julie L. Williams, Acting Comptroller of the Currency Before the BAI National Loan Review Conference, New Orleans, LA, March 21, 2005
8 Charles Duhigg, "What Does Your Credit Card Company Know About You?", New York Times, May 12, 2009
9 "Account Management and Loss Allowance Guidance" Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of Thrift Supervision