Beyond today’s crisis is a new market where up-front selectivity will be a defining factor in credit card competition. Analytically-based strategies will be essential.

Proactive Card Strategy: The Economy, UDAP and Next Steps BY RICHARD TAMBOR

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or years, the credit card industry succeeded with mass-

market strategies on the front end and exception-based strategies on the back end. Giant scooping mechanisms, such as zero-interest introductory rates, attracted throngs of new cardholders. Afterwards, rates and terms could be individually adjusted depending on usage and repayment patterns. The model had its messy aspects but was enormously profitable. Now, however, the foundations of the credit card industry’s traditional customer acquisition and profit optimization model have been shattered. The expanding economy that fueled credit demand and kept borrowers generally afloat on their debt obligations is long gone. Broad-based marketing initiatives will need to be reexamined in the face of an inhospitable market where customer variations no longer reliably offset

each other. And new federal regulations will substantially limit the ability of card issuers to make critical account adjustments on the fly. Clearly, there is a growing need to reformulate strategies for customer acquisition and relationship profitability. Simply following traditional practices more carefully won’t work, given that the fundamentals have been exploded. Beyond today’s crisis is a new market where up-front selectivity will be a defining factor in card competition. In this new playing field, the most successful issuers will: 1) accurately target the most promising customer segments within the overall market; 2) develop new value propositions for customer acquisition that do not rely on giveaway interest rates; 3) do a far better job of front-loading pricing and underwriting considerations in new account relationships; and 4) assure that operating models are appropriately tailored to support initiatives with target customer segments. A fresh blend of skills and strategies will be needed to meet this important challenge. In a world where the ability to make reactive adjustments will be limited, for example, an analytical understanding of customer price elasticity of demand is essential in forging up-front profitable relationships Another requirement is advanced risk modeling that looks beyond FICO scores to assess – and anticipate – cardholders’ fundamental ability to repay their obligations.

CUSTOMER ACQUISITION STRATEGY The introductory offer has been a centerpiece in new account acquisition in recent times and still is used extensively. Yet from the Novantas perspective, we believe this marketing tool serves as a prime example of how traditional practices will need to change in an emerging card market where issuers will have far less flexibility in making onthe-fly adjustments to account relationships. Featuring low (often zero) initial interest rates on purchases and balance transfers, introductory credit card offers typically are extended to a broad pool of prospects, with the goal of converting some portion of recipients into long-term customers who eventually will carry balances at market rates. This arrangement was never perfect. One longstanding drawback is the tendency of “rate surfers” to maintain balances only until the introductory offer expires. Another drawback is that introductory offers can be a magnet for overextended borrowers who tap cheap credit just to stay afloat – and pile up more risky balances as they go along. In both cases, the bill is ultimately footed by stable customers who maintain balances beyond the introductory period and incur the accompanying higher rates.

“Given the wrenching dislocations in the global credit markets and severe U.S. domestic economic contraction, we anticipate an extended period of deleveraging, both at the household and commercial level.” Despite its awkwardness, the promotional pricing strategy for customer acquisition enjoyed two powerful sustaining factors that made it workable and profitable for issuers. One was an expanding economy that propped up credit demand and household finances. Another was considerable issuer latitude to revise account terms and rates on the fly. In such circumstances, the benefits from profitable long-term account relationships more Novantas Viewpoint Series, April 2009

than offset the costs and risks of using mass-market techniques to acquire them. But no more. Eroding Fundamentals. Falling home values and rising unemployment will continue to undercut household borrowing and debt servicing capacity. In turn, issuers will need to be far more selective in new account acquisition. At a time when U.S. households generally are overburdened with debt, there is a risk that cards increasingly will be used as a source of consumer working capital by stretched borrowers. Meanwhile, many households on sounder footing will be focusing on paying down balances. This behavioral skew between sound and stretched borrowers will place further stress on portfolio risk dynamics that already have been battered by the ongoing U.S. recession. Along with risk degradation is the distinct possibility of an extended slackening in overall credit demand. Given the wrenching dislocations in the global credit markets and severe U.S. domestic economic contraction, we anticipate an extended period of de-leveraging, both at the household and commercial level. It will take time to unwind the borrowing and spending excesses of the past decade, as reflected the following statistics:  An 80% increase in U.S. household indebtedness since 2001 was more than double the 36% rise in consumer disposable personal income occurring during the same period.  Over the last decade, the average household debt load rose from 92% of disposable personal income to 135.9% of DPI.  As a percentage of home market value, average homeowner equity fell from 70% in the 1980s to 50% in 2007, and as-yet-to-be-reported figures for 2008 can only look worse.  Compared with a savings rate close to 9% in the 1980s, the U.S. savings rate has been less than 3% of DPI in recent years – down by at least two thirds.  Roughly one of every eight U.S. households is carrying more than $25 thousand in total bank card balances. The extensive hangover from these excesses creates an inhospitable climate for mass-market customer acquisition strategies. Issuers must be much more selective in extending credit at a time when households already are overloaded with debt. Eroding Flexibility. Another impetus for greater up-front selectivity in customer acquisition is the fact that account terms, conditions and pricing will 2

be less easy to adjust going forward. Under the Treasury Department’s new regulations regarding Unfair and Deceptive Acts and Practices (UDAP) credit card issuers will need to provide clearer disclosures of terms and conditions, and also restrict certain practices with regard to the application of payments and re-pricing of accounts. The most significant changes in terms of financial impact to card issuers are:  Restrictions on the timing and conditions under which issuers may re-price outstanding card balances. This includes 1) expanded disclosure requirements at the time of account opening; 2) extended customer notification periods; and 3) the curtailment of most “back-end” pricing flexibility for issuers.  Restrictions on the timing and notification of penalty or “default” pricing, including delaying the trigger for re-pricing from one day past due to 30 days past due, and requiring 45-day advance notice to customers.  The requirement to allocate payments in excess of the “minimum payment” to the balance with the highest rate first – or at least pro rata among all balances – as opposed to the current practice of retiring lowest-rate balances first.  The prohibition of calculating interest due based on average balances maintained during the two previous billing cycles. These changes will ultimately compress yields for existing portfolios and reduce expected value of prospective new accounts as well. COURSE CORRECTIONS We believe that economic and regulatory headwinds are steadily undercutting broad-based marketing offers, with their flawed dependencies on customer cross-subsidies and reactive adjustments. As issuers look forward, differentiated pricing and fee strategies will be crucial in rebuilding margins in a post-UDAP environment. One priority is a general realignment of riskbased pricing, which will have the effect of raising risk premiums and also restricting the circumstances in which credit is granted. Another is doing a better job of setting the “sticker price” of credit, guided by analytical insights into the price elasticity of customer demand. Segment-based insights and initiatives also will be critical. With overall profitability under pressure, overlooked/unanticipated shortfalls in one area of the portfolio won’t necessarily be offset by Novantas Viewpoint Series, April 2009

strengths elsewhere. Segment insights indispensible in proactive efforts to exposure to unacceptable risk, limit the low-potential accounts, and make the promising customer relationships.

will be minimize intake of most of

“Segment insights will be indispensible in proactive efforts to minimize exposure to unacceptable risk, limit the intake of low-potential accounts, and make the most of promising customer relationships.” In terms of specific, practical initiatives, priorities include:  Identifying the most debt-burdened households, analytically distinguishing between those that are most and least likely to fail, and developing pricing and/or product responses that will either enhance profitability or minimize loss.  Enhancing risk-based pricing and informing strategies with a deeper understanding of price elasticity of demand, providing guidance on appropriate rates where credit is in greatest demand and/or where capital is at greatest risk.  Reducing rate-surfing and the dead-weight loss it represents. Given that the new UDAP regulations do not come in to effect until July 2010 and any interim legislation will have a 90 day enactment window, pricing strategies for current portfolios and new customer acquisition can be divided into pre- and post-enforcement time frames. PREEMPTIVE MEASURES Before impending pricing constraints kick into action, there may be opportunities to adjust portfolio profitability dynamics under the current regulatory guidelines. In essence, an issuer would stress-test the current portfolio to identify segments of accounts where current pricing does not provide an adequate risk- adjusted return, and then ascertain how much additional yield is needed to meet internal profitability hurdles. 3

Ideally this exercise should be informed with an understanding of the relative price elasticity of accounts that currently are underwater from the perspective of risk-adjusted profitability. It does no good, for example, to lift rates so high that customers stop using their cards altogether. Such thresholds can be analytically identified. In instances where re-pricing proves infeasible, issuers can pull other customer management levers (credit lines, fees, aggressive credit management) to improve the profitability outlook. Issuers would also benefit by proactively identifying overextended customers who may be unable to recover on their own (other than through bankruptcy). There may be an early mover advantage in exiting pressurized relationships, either to avoid being the lender of last resort or the eventual loser in multi-creditor collection scenarios. A bold example of pre-emption is the recently announced American Express strategy to pay customers to transfers their balances elsewhere. The obvious goal is to encourage the exit of risky accounts. For other issuers considering this strategy, however, the interesting empirical question is how solid customers will react to such offers. If preferred customers “cash out” at a greater rate than shaky borrowers, the residual portfolio could be even more toxic than when the exercise began. POST-UDAP STRATEGIES Given that UDAP will severely restrict the ability to re-price based on changing assessments of riskrelated behaviors, U.S. card issuers will need to completely rethink “teaser” or promotional introductory and balance transfer pricing. Such promotions are based on a few key mathematical assumptions, including:  The percentage of balances that will run off at the end of the promo period and the resulting steady state balances.  The percentage of good accounts that will continue to revolve after re-pricing to market rates.  The percentage of new customers who will lose their promotional price by tripping a default trigger, thereby raising the expected average yield. As long as the math works on average, the promotional pricing strategy works. The problem is the math is changing. It is likely that there will be a sustained period of consumer household de-leveraging, scaled back consumer spending, and relatively more expensive Novantas Viewpoint Series, April 2009

credit for marginal borrowers as a result of steeper risk-based pricing. For issuers, the rationale response may well be a flight to quality. In turn, the “hot money” strategies of gathering balances with aggressive promotional pricing should be far less attractive for the foreseeable future. As they back away from aggressive “zero interest” promotional offers, issuers will place much greater emphasis on acquiring customers whose engagement will be driven by relevant rewards, enhanced customer experience, and relationship value. Although a full discussion of the non-price drivers of customer acquisition is beyond the scope

The Role of Enhanced Analytics As issuers re-think marketing strategies in a world where the quality of up-front pricing and credit decisions will be critical, there’s a strong need to beef up core analytical capabilities. Both with prospects and established customers, successful interaction will hinge on a keen understanding of the profiles and behaviors of customer segments. As we have pointed out in previous articles, for example, credit scores and monthly payment trends may not provide adequate guidance on credit extension to current customers. In some cases, an analysis of risk-adjusted account profitability reveals stretched-but-solid borrowers who may actually warrant credit line increases. In other cases it reveals the need for active intervention with households having clean payment histories, yet teetering at the brink of financial crisis. In dealing with delinquent borrowers, in-depth risk analysis is invaluable in guiding negotiating tactics and mass-customized workout programs. Troubled borrowers having substantial remaining assets, few credit lines and deep ties to the institution, for example, present a starkly different profile than debtors in the opposite condition. As for elasticity-based pricing, issuers must learn to strike more precise tradeoffs between margin enhancement and balance formation, which will require careful study of customer responses to rate changes. This is in the spirit of tapping pockets of opportunity within the overall market, something issuers increasingly must do in world where the unintended consequences of general outreaches are far less tolerable.

– Richard Tambor

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of this article, the topic is of enormous importance going forward. In brief, we would say that while card issuers have indeed invested considerable effort into understanding myriad types of customer groups, an even deeper level of analysis is needed to pinpoint the non-price factors that move the dial in acquisition, retention and relationship expansion. Too often today, precision in establishing segment identities and attitudes is accompanied by little more than internal speculation as to how that knowledge can be used to encourage profitable customer behaviors. IN SUMMARY UDAP will fundamentally alter the “cross-subsidy” implicit in current industry pricing practices, where good borrowers wind up footing the bill for issuers’ aggressive acquisition tactics and rate surfers impose a dead-weight loss on a credit system that can ill afford it. Moving away from “teasers” and a flight to quality is a logical response. One potential side effect is that the reduction of introductory offers may impact struggling households who have come to rely on them for interim financing. Among the myriad U.S. households that are overburdened with debt, both voluntary and involuntary (i.e. bankruptcy) de-leveraging likely

will continue for some time. To protect margins and lay the groundwork for future competition, issuers will need to develop robust (re)pricing strategies which are informed by debt burdens and debt servicing capacity, risk insights and customer elasticity. Improved pricing and risk analytics will be needed to support this effort (see sidebar). Heightened customer and competitor analysis also will be required. There likely will be more attempts at pre-emptive re-pricing and shedding of overstressed accounts across the industry. Issuers will need to determine which segments of the current customer base are at risk, and develop both offensive and defensive strategies for dealing with them. As part of this, prowess in competitive game theory will be helpful in assessing how various strategies and actions may play out in the market. This includes anticipating possible competitor actions and their impact, as well as examining how various possible company initiatives likely would affect competitors.

Richard Tambor is a managing director in the New York office of Novantas LLC, a management consultancy.

Novantas LLC 485 Lexington Avenue New York, NY 10017 Phone: 212-953-4444 Fax: 212-972-4602

www.novantas.com Novantas LLC 311 South Wacker Drive Chicago, IL 60606 Phone: 312-924-4444 Fax: 312-924-4440

www.novantas.com Novantas Viewpoint Series, April 2009

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