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									                                                                                                                                       March 1, 1988

                                                                  Federal Reserve Bank of Cleveland

----              The Bank Credit-Card
                  Boom: Some Explanations
                  and Consequences

                  by Paul R Watro

                  I n financial activities, there is a trade-    In view of the expense, the risk, and
                  off between risk and return. The               the higher rate of charge-offs, are         What is behind the surge in credit-
                  higher the risk, the greater the               banks acting irrationally when they try     card lending and the sharp rise in
                  required return.                               to increase their credit-card lending       credit-card charge-off rates at banks?
                                                                 business? The answer depends on the         Factors related to risk-taking help
                  This fundamental principle helps
                                                                 trade-off between risk and return.          explain why some banks have higher
                  explain why credit-card interest rates
                                                                                                             charge-off rates than others.
                  are still in the 17-18percent range,           In this article, we discuss factors
                  even though rates on most other                behind the surge in credit-card lend-
                  kinds of bank loans have fallen signif-        ing, and identify factors related to
                  icantly since the early 1980s.                 risk-taking that help explain why
                                                                 some banks have higher charge-off           to 20 percent in 1982. This growth
                  Credit-card loans have higher interest
                                                                 rates than others.                          has occurred even though lenders
                  rates because they generally lack col-
                                                                                                             charge higher rates on credit-card
                  lateral and involve more risk. If such         • Consumer Demand
                                                                                                             loans than on other consumer loans,
                  loans are not repaid, banks often must         Consumer spending has propelled
                                                                                                             such as auto loans. One reason for
                  charge them off and suffer a loss.             economic growth, particularly in the
                                                                                                             the higher rates is that credit-card
                                                                 early years of the current economic
                  In the last three years, the rate of such                                                  credit has no collateraJ.2 If the card-
                                                                 expansion, which began in November
                  charge-offs has more than doubled,                                                         holder defaults, the credit-card issuer
                                                                 1982.1 Rising income levels and
                  indicating a decline in credit quality.                                                    is without recourse against the mer-
                                                                 improved wealth positions have con-
                  In spite of this, however, strong con-                                                     chandise purchased with the card.
                                                                 tributed to increased consumer
                  sumer demand and attractive profit
                                                                 spending. Consumers have also been          The growing popularity of credit
                  margins have led to greater credit-
                                                                 borrowing more. For instance, con-          cards may be attributed to many fac-
                  card lending by banks.
                                                                 sumer installment debt as a percen-         tors. From a user standpoint, accep-
                  This increased lending comes at a time         tage of disposable personal income          tance, convenience, safety, and flexi-
                  when fewer potential customers are             rose from 14 percent in 1982 to over        bility have encouraged consumers to
                  without credit cards and when banks            18 percent in the last year or two.         make greater use of charge cards.
                  are using market segmentation to com-                                                      Credit-card transactions provide users
                                                                 Credit cards have been the fastest-
                  bat the more intense competition,                                                          with a convenient way to maintain
                                                                 growing form of consumer credit. In
                  which has made growth in credit· card                                                      records for tax and other purposes
                                                                 the last five years, credit-card balances
                  operations more expensive.                                                                 and a way to minimize the risk and
                                                                 have more than doubled and now
                                                                                                             financial cost of carrying large cash
                                                                 account for nearly 25 percent of all
                                                                 consumer installment debt, compared

 ISSN 0428·1276
balances. Credit cards might even be
superior to checks or cash for some
transactions, such as those in foreign
countries and those over the tele-
phone and through the mail.
                                            credit-card interest rates enable banks
                                            to buffer the expected higher credit
                                            losses associated with lending to risk-
                                            ier customers.

                                            Credit-card accounts may be more
                                                                                       Credit-card performance was also quite
                                                                                       poor during the developing stages of
                                                                                       bank credit-card systems." In addition
                                                                                       to operating problems, banks under-
                                                                                       estimated the burden of controlling
                                                                                                                                   CHART 1 NET PRETAX PROFIT MARGINS ON
                                                                                                                                           VARIOUS lYPES OF BANK CREDIT

                                                                                                                                            Percent credit type outstanding
                                                                                                                                                                                                                                  • Credit Quality
                                                                                                                                                                                                                                  One widely used measure of loan
                                                                                                                                                                                                                                  quality is net charge-offs.w These are
                                                                                                                                                                                                                                  loans judged to be uncollectable in a
                                                                                                                                                                                                                                  given year, minus any recoveries of
• Banks' Role                               valuable than their direct dollar
                                                                                       credit losses. In an effort to grow and
                                                                                       to gain market acceptance, banks
                                                                                                                                             6~----------------------------------~                                                loans previously charged off. Banks
                                                                                                                                                                                                                                  generally write off unsecured loans,
Spurred by growing consumer                 return if they provide banks with use-
                                                                                       turned to mass mailing of unsolicited                                                                                                      such as credit-card receivables, faster
demand, high returns, and declining         ful marketing and credit information.
                                                                                       credit cards during the late 1960s.This                                                                                                    than well-secured loans like home
commercial lending profits, many            For instance, banks could judge the
                                                                                       marketing strategy led to large-scale                                                                                                      mortgage loans.
banks have placed greater emphasis          credirworthiness of cardholders for
                                                                                       credit and fraud losses, that, in turn,
on consumer lending, especially on          larger loans based on their payment                                                                                                                                                   Chart 2 shows that bank credit-card
                                                                                       led to legislation prohibiting the unsol-
credit-card lending. As a percentage        history. Some banks, such as Citibank,                                                                                                                                                quality has deteriorated. Net charge-
                                                                                       icited distribution of credit cards.'                 3
of total bank loans, credit -card receiv-   have apparently used credit-card cus-                                                                                                                                                 offs as a percentage of credit-card
ables jumped from 3 percent in 1982         tomers as target groups for selling        Despite a shaky track record, the                                                                                                          balances have more than doubled,
to over 5 percent by year-end 1986.         insurance products and for penetrat-       recent prosperity in credit-card earn-                2                                                                                    jumping from 1.5 percent in 1984 to
Banks now hold close to two-thirds of       ing out-of-state markets. Moreover,        ings has spurred new entrants and                                                                                                          3.2 percent in 1986.The deterioration
the credit-card outstanding balances,       banks typically include advertise-         more intense competition in the                       1                                                                                    reflects many factors, some and per-
up from just over one-half in 1982.         ments in monthly bill statements in        credit-card business. A few years ago                                                                                                      haps the most important of which have
                                                                                                                                                                                                                     and other
                                            an effort to sell other banking servi-     Sears introduced the Discover Card,                                                                                                        no relation to the business cycle.
Technological advances, economies of
                                            ces to credit-card customers.              which has not become profitable yet."
scale, deregulation, and favorable mar-                                                                                                                                                                                           In our study, we examine 148 large
                                                                                       American Express also introduced the
ket conditions have encouraged lend-
ers to mass-market credit on a nation-
                                            Perhaps earnings have been the
                                            underlying force behind the rapid
                                                                                       Optima card, which offers a revolving
                                                                                                                                             -1                                                 \I                                banking organizations to identify the
                                                                                                                                                                                                                                  level and variability of credit-card
                                                                                       credit line with a lower interest rate
wide basis. Banks issuing credit cards      expansion in credit-card operations at
                                                                                       than most bank cards."                                -2~--~----~--~----~--~----~--~--~
                                                                                                                                                                                                                                  charge-off rates among individual
face sizable volume requirements in         banks. Chart 1 shows that credit-card                                                                         1973      1975      1977       1979        1981     1983        1985    banks. We look at banking organiza-
order to achieve profitability because      profit margins have improved sharply       With greater competition and fewer                         NOTE: Based on annual data from the Federal Reserve System's Functional Cost    tions as a unit rather than as individ-
of high operating costs. This is why        and have been better than those from       consumers without credit cards, how-                       Analysis.                                                                       ual banks because some organiza-
many banks that offer credit cards          other types of lending in recent years.'   ever, large-scale expansion is probably                                                                                                    tions have shifted credit-card balances
participate with larger banks or organ-     From 1984 through 1986, the annual         becoming more expensive and more                                                                                                           among subsidiary banks. In fact, more
izations that actually issue cards and      pretax net returns on bank credit-card     risky. Nevertheless, mass solicitations                                                                                                    than 20 bank holding companies
determine their rates, fees, and serv-      balances averaged 3.6 percent. In the      with preapproved credit lines, waived                                                                                                      operate special banks dealing primar-
ice features.' Because of economies         same period, banks earned 2.4 per-         annual fees, and other enticements          CHART 2 NET CHARGE-OFFS ON BANK CREDIT CARDS                                                   ily in credit-card accounts."
of scale in credit-card operations,         cent on real estate mortgages, 2.7         continue to be common among large                   (AS A PERCENT OF CREDIT-CARD AVERAGE BALANCES)
                                                                                                                                                                                                                                  Our sample included all bank hold-
banks have an incentive to expand           percent on consumer installment            issuers.
                                                                                                                                                                                                                                  ing companies established before
and become the low-cost issuers.'           debt and 1.4 percent on commercial
                                                                                       In an effort to build consumer loyalty,               4                                                                                    1982 that have a subsidiary bank with
                                            and other loans. Bank credit-card
When the cost of money fell signifi-                                                   many banks have sought to tie credit                                                                                                       assets over $1 billion and that have
                                            returns have benefited not only from                                                                                                                                  3.2
cantly in the mid-1980s, banks gener-                                                  cards to affinity groups such as air-                                                                                                      total credit-card receivables of more
ally sought to expand credit-card
lending through mass-mailing solici-
                                            the robust consumer demand, but
                                            also from the removal or relaxation of
                                                                                       lines, hotel chains and alma maters                   3    -                                      2.4
                                                                                                                                                                                                                                  than $25 million. These banking
                                                                                       during the past year or rwo. The                                                                                                           organizations hold 80 percent of bank
                                            state usury laws in the early 1980s
tations with preapproved credit.                                                       sponsoring organization typically                                                                                                          credit-card receivables and accounted
                                            and from the large decline in funding                                                            2~
Banks have largely relied on credit-                                                   endorses the bank's card for financial                                     1.5                                                             for nearly 85 percent of credit-card
                                            costs from those years.
card availability and services rather                                                  compensation based on members'                                                                                                             charge-offs at banks in 1986.
than on price in issuing cards.             Over a longer period, however,             acceptance and use of the card, While                 1~
                                                                                                                                                                                                                                  Credit-card charge-off rates varied
                                            credit-card profits look quite differ-     aggressive marketing and liberal
Credit-card issuers generally have                                                                                                                                                                                                considerably among our bank sam-
                                            ent. Credit-card issuers experienced a     credit policies have promoted credit-
increased credit limits, have provided
                                            severe profit squeeze in the 1979-81       card growth, some of the expansion                    o                   1984                   1985                     1986
                                                                                                                                                                                                                                  ple. Net charge-offs as a percentage of
a wider range of enticements, and                                                                                                                                                                                                 credit-card balances ranged from -0.6
                                            period because of historically high        came at the expense of loan quality.
have offered credit to riskier groups                                                                                                                                                                                             to 8.9 percent and averaged 2.2 per-
                                            interest rates and binding usury laws.                                                                NOTE: Based on data from reports of income and condition   for all banks.
of consumers who were previously                                                                                                                                                                                                  cent for 1986.12 Charge-off differen-
                                            Credit-card earnings were generally
unable to obtain credit cards. The                                                                                                                                                                                                ces could be due to numerous factors
                                            more volatile and lower than earnings
spreads berween funding costs and                                                                                                                                                                                                 including differences in luck, eco-
                                            from other loans. Greater volatility
                                                                                                                                                                                                                                  nomic conditions, and risk-taking.
                                            may have reflected a combination of
                                            factors, including changes in the cost
                                            of funds, binding usury ceilings, and
                                            the higher degree of default risk in
                                            credit-card lending.
                                                                Group          Difference
                                                                                                    We use two common tests to ascer-
                                                                                                    tain whether or not credit-card
                                                                                                    growth, specialization, volume,
                                                                                                    revenue, loan-to-asset ratios, and
                                                                                                    organizational size had any influence
                                                                                                    on charge-off rates. First, we compare
Credit-card balances/                             7.9%            3.7%          4.2%a               the sample extremes-those with the
  total loans                                                                                       highest and lowest charge-off rates.
Change in credit-card balances/                    2.5            -1.0            3.5a              The high group included those with
  total loans (1983 to 1985)                                                                        charge-off rates greater than 4.0 per-
                                                                                                    cent and the low group included
Loans/assets                                      63.9            60.8            3.1               those with charge-off rates less than
Revenues from credit-cards/                        19.3           14.9           4.4a               1.0 percent. For each variable, average
  average credit-card balances                                                                      values were computed for both
                                                                                                    groups and the difference was tested
Credit-card balances (billions)                   $1.8            $0.1           $1.7b
                                                                                                    for statistical Significance. Second, to
Assets (billions)                                 27.8             5.0          22.8b               explain differences in charge-off rates
                                                                                                    for the whole sample, we use a statis-
               a. Denotes statistical significance at the 1 percent level.
               b. Denotes statistical significance at the 5 percent level.
                                                                                                    tical technique that isolates the effects
               NOTE: Data are as of year-end 1986, unless otherwise noted.                          of one variable while taking into
               SOURCE:Federal Financial Institutions Examination Council's Reports of Income and
               Condition for banks.
                                                                                                    account other factors.
                                                                                                    Our analysis, as expected, revealed
                                                                                                    that the 18 banking organizations in
                                                                                                    the high-charge-off group differed
We examine credit-card growth, spe-                      There is a positive relationship be-       Significantlyfrom 21 banking organi-
cialization, volume, revenue, loan-to-                   tween risk and returns. Lenders charge     zations in the low-charge-off group.
asset ratio and organizational size as                   higher rates or require higher reve-       The table shows that the high-charge-
potential explanatoiy factors for                        nues for riskier loans. Accordingly, one   off banks were much larger, placed
interbank charge-off differences. Each                   would expect to find higher credit-card    greater emphasis on credit-card lend-
of these factors is related to risk-                     charge-offs at banks that generate         ing, and charged higher prices. The
taking in one way or another.                            higher revenues per dollar of credit-      high-charge-off organizations expe-
                                                         card balances. We also examined            rienced much faster credit-card
Banks that experience faster credit-
                                                         loan-to-asset ratios as a measure of an    growth and, on average, they held
card growth might be expected to in-
                                                         organization's overall attitude towards    $1.8 billion in credit-card receivables,
cur higher charge-offs because a trade-
                                                         risk. Higher ratios are thought to         which accounted for nearly 8 percent
off may exist between credit growth
                                                         reflect greater risk-taking since loans    of their loans. Average credit-card
and credit quality. Lenders that spe-
                                                         are usually riskier than other assets,     revenues generated by the high-
cialize in or devote more resources to
                                                         such as government securities.             charge-off group were 4.4 percent
a certain type of lending may also be
                                                                                                    higher than the low-charge-off group.
more aggressive and extend riskier                     Product and geographical diversifica-
lines of credit in those areas. Alterna-               tion helps to reduce risk. The largest       Although we do not know if higher
tively, those banks may be better at                   credit-card issuers with a nationwide        revenues were sufficient to offset
managing risk. Specialization is mea-                  customer base should have more               higher default costs, this finding sug-
sured by the current share of loans                    geographically diversified portfolios        gests that banks are taking credit risk
held in credit-card receivables and                    that could lower charge-off rates. On        into account at least to some degree
growth is measured by the change in                    the other hand, the largest banking          when pricing credit cards. Higher
this ratio over the two previous years.                organizations might choose to have
                                                       lower credit standards for issuing
                                                       credit cards because of potentially
                                                       lower risk levels from greater product
                                                       and loan diversification.

                                                                                                   Credit-card charge-offsvaried consider-
                                                                                                   ably among issuers. Banks with higher
                                                                                                   propensities to take risk incurred
                                                                                                   higher charge-off rates. As long as
                                                                                                   issuers receive adequate compensa-
                                                                                                                                                   •   Footnotes
                                                                                                                                                   1. See K.]. Kowalewski, "Is the Consumer
                                                                                                                                                   Overextended?,"  Economic Commentary,
                                                                                                                                                   Federal Reserve Bank of Cleveland,
                                                                                                                                                                                                        6. Peter S. Rose, "The Promise and the
                                                                                                                                                                                                        Peril," The Canadian Banker & ICB
                                                                                                                                                                                                        Review, Volume 85, November 6,
                                                                                                                                                                                                        December 1978, pp. 64-65, and Joel P.
                                                                                                   tion for credit risk, however, charge-          November 1986.                                       Friedman, "Golden Goose or Ugly Duck-
                                                                                                   offs are not necessarily a problem.             2. However, this does not necessarily
                                                                                                                                                                                                        ling?," ABA Banking journal, September
               2 0-                                                                     19.3                                                                                                            1986, pp. 73-77.
                                                                                                   Also, the potential impact of high              explain why credit-card rates have not
                                                                                                   credit-card charge-offs on the financial        fallen in tandem with other loan rates.              7. The Consumer Protection Act (October
               18-                                                      17.4                       condition of banks is reduced by the                                                                 1970) also limited the cardholder's legal
                                                                                                                                                   3. There are approximately 3,000 banks
                                                         16.9                                                                                                                                           liabiliry for unauthorized use of the card
                                                                                                   fact that even the most aggressive              and other institutions that issue credit
                                                                                                                                                                                                        to a maximum of S50.
                                                                                                   banks in credit-card lending still have         cards. "Interest Rate Controls on Credit
               16-                                                                                                                                 Cards - An Economic Analysis," Lexicon,             8. "Sears Is Discovering Discover Credit
                          14.9                                                                     relatively small portions of their assets                                                            Card Isn't Hitting Pay Dirt," Wall Street
                                                                                                                                                   Inc., October 1985.
                                                                                                   and loans in credit-card receivables.                                                               journal, February 10, 1988, p. 1.

               14-                                                                                                                                 4. See Christine Pavel and Paula Binkley,
                                                                                                                                                   "Costs and Competition in Bank Credit                9. Kathleen Hawk, "Plastic Warfare," U.S.
                                                                                                                                                   Cards," Economic Perspectives. Federal               Banker, June 1987, p. 40.
                0                       1.0-1.9                                                                                                    Reserve Bank of Chicago, March-April                 10. Delinquencies,    or past due loans, are
                      Less than 1                      2.0-2.9         3.0-3.9         4.0-8.9
                                                                                                                                                   1987, pp. 3-13. The authors found econo-             another measure of loan qualiry, but some
                                                  Net charge-offs                                                                                  mies of scale in credit-card operations for
                                                                                                   Paul R. Watro is an economist at the Federal                                                         of these figures are treated as confidential
                                                                                                   Reserve Bank of Cleveland.        The author    a sample of small- and medium-size banks.            by bank regulations.
                  NOTE: Based on 1986 data from reports of income and condition for bank sample.
                                                                                                    would like to thank john M Davis, Mark S.      5. Figures are based on data provided by             11. A list of so-called credit-card banks is
                                                                                                   Sniderrnan, andjamesB.      Tbomson for belp-   banks participating in the Functional Cost           provided by the American Banker, January
                                                                                                   ful comments. Research assistance was pro-      Analysis of the Federal Reserve System. For          4, 1988, p. 15.
                                                                                                    vided by john N. McElravey and Daniel].        a discussion of credit-card profitabiliry, see
charge-offs, therefore, do not neces-               Other results were also similar to the                                                                                                              12. The weighted average net charge-off
                                                                                                   Martin.                                         Glenn Canner and James Fergus, "The
sarily imply inferior performance or                findings listed in the table." One                 The views stated herein are those of the    Effects on Consumers and Creditors of
                                                                                                                                                                                                        rate was 3.4 percent for the sample.
cause for immediate concern, as long                important exception was that credit-           author and not necessarily those of the Fed-    Proposed Ceilings on Credit Card Interest           13. Credit-card charge-off rates were
as lenders are being adequately com-                card balances were found to be nega-            eral Reseroe Bank of Cleveland or of the       Rates," Staff Study 154, Board of Governors         regressed on the six variables listed in the
                                                                                                   Board of Governors of the Federal Reserve                                                           table. Each of the variables except credit-
pensated for credit risk.                           tively related to charge-off rates when                                                        of the Federal Reserve System, October
                                                                                                   System.                                         1987.                                               card balances was positively and statisti-
                                                    asset size was taken into account.                                                                                                                 cally related to credit-card charge-offs at
The strong positive relationship
                                                    This finding, although statistically                                                                                                               least at the 5 percent level of significance.
between revenues and charge-offs is
                                                    Insignificant, is consistent with the                                                                                                              The variables collectively explained 40
also depicted in chart 3. The chart                                                                                                                                                                    percent of the variance in the credit-card
                                                    view that larger portfolios are gener-
shows average credit-card revenues                                                                                                                                                                     charge-off rates across the 148 banking
                                                    ally more diversified and carry less
for the whole bank sample broken                                                                                                                                                                       organizations that were examined.
                                                    risk than smaller portfolios.
out into five groups according to the
level of credit-card charge-offs. Banks             • Conclusion
in the higher charge-off groups pro-                Bank credit-card lending has
gressively earned higher revenues,                  increased rapidly since the early
suggesting that they charge higher                  1980s.This increase has been fueled
rates and fees but lend to riskier                  by a range of factors, including robust                                                                                                                                                                                                    BULK RATE
customers.                                          consumer demand, improved tech-                                                                Federal Reserve Bank of Cleveland                                                                                                         U.S.Postage Paid
                                                    nology, removal or relaxation of state                                                         Research Department                                                                                                                        Cleveland, OH
However, the loan-quality/revenue                                                                                                                                                                                                                                                            Permit No. 385
                                                    usury laws, economies of scale, cross-                                                         P.O. Box 6387
relationship could be spurious, that
                                                    selling potential, substantial decline                                                         Cleveland, OH 44101
is, other factors could be causing it.
                                                    in funding cost and attractive profit
When we isolated the influence of
                                                    margins. Higher credit-card earnings
individual factors while taking into
                                                    have attracted new competitors, more
account other factors, such as asset
                                                    aggressive marketing and more lib-
size and the percentage of loans in
                                                    eral credit standards that, in turn, led
credit-card balances, we still found
                                                    to a sharp rise in credit-card losses.
that banking organizations with higher
credit-card charge-offs had signifi-
cantly higher credit-card revenues.

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