Today’s credit card landscape is growing more complex as it evolves with the rapidly changing macroeconomic and regulatory environment. When considering an effective pricing strategy, there are many variables credit unions need to address to ensure a safe and effective return. With new regulation, it is more critical than ever to make sure your pricing strategy is addressing risk and return at the individual applicant level upon approving the account.
Looking from the top down, there are more than $850 billion in credit card loans outstanding across North America. Within this population, there exist thousands of varied pricing strategies that consider factors such as introductory rates, go-to rates, risk-based pricing, and product profitability. However, the most under-considered and yet critically important strategy involves the decision of whether to offer credit cards with a fixed or variable rate structure.
The top four national issuers, based on portfolio size, all tend to source new accounts with an aggressive promo rate followed by a variable long-term rate. When comparing their lead rewards products in terms of pricing, there exist substantial similarities (see Figure A below):
|Issuer||CC Assets (etc.)||Base Product Pricing|
|Bank of America Corp.||$125B||Prime based variable APR (~12.99% to ~22.99%)|
|JP Morgan Chase Co.||$117B||Prime based variable APR (~13.99% to ~22.99%)|
|Capital One Financial Corp.||$80B||Prime based variable APR (~11.99% to ~20.99%)|
|Citibank NA||$144B||Prime based variable APR (~12.99% to ~22.99%)|
Credit unions tend to leverage a different viewpoint than national banks. As an example, many credit unions today have fixed priced credit card portfolios. When comparing a subset of credit unions with credit card portfolios of $200MM to $500MM, different pricing trends become evident as presented in Figure B:
Approximately 40% of credit unions choose to manage fixed priced credit card portfolios versus nearly none of the national bank issuers. What points may have been considered to drive these vastly different strategies? More than likely, senior leaders within each segment have come to different conclusions on how to understand the risks, mitigate the risks, and leverage the benefits of fixed priced unsecured assets.
Rate Risk — Many financial institutions choose to variably price their credit card portfolio to mitigate the risk of rate increases in the future. Since January 1, 2000, rates have consistently fallen then remained low, whether measured by industry average Cost of Funds, Prime Rates, or the 10-year treasury (see Figure C). The primary benefit of a variably priced credit card becomes clear when funding rates start to rise and the APRs on the card rise in conjunction. Conversely, a fixed priced portfolio is subject to margin compression as rates increase, significantly impacting profitability. Given unprecedented liquidity that the Fed has pumped into the system (see Figure D), when it moves to mop up that liquidity and short term rates rise, there is a risk of unintended consequences on financial institutions. When considering both the duration and recent upticks in the current low rate environment, one may ask “How much longer will the fixed price strategy work?” and “What options do I have to mitigate margin compression?”
Duration Risk — Another commonly overlooked variable is the duration of a typical credit card loan. When booking a credit card loan, it is not safe to assume that a credit card loan represents a short duration loan. As demonstrated by Kohl Advisory Group’s 2013 study, the average life on book for a non-reward credit card loan is 5.5 years and 6.6 years for a reward product. The longevity on credit card loans exceeds the average of 2 years for a used auto loan and 5.2 years on a fixed rate first mortgage. Although the study looks at time on books and not the mathematical Macaulay Duration of the loan, the results of the study are a good place to start thinking about the impact rising rates will have on the assets of the credit union. If rates begin to rise, financial institutions with longer duration assets will miss out on opportunities to invest at those higher rates as well as the diminished value of the lower rate loans. Any financial institution will have to react quickly to mitigate the risk associated with the challenging combination of a long-duration loan that is situated at a fixed price point.
Risk Based Pricing — The simplest and most effective way to risk-base price a credit card loan is at the time of booking. To properly leverage a fixed priced APR strategy, an institution will have established multiple price points per product within the targeted pricing range. Rates must be low enough to attract your best credit qualified members while at the same time high enough to increase the likelihood of acceptance for all members. While this seems initially complex compared with the simplicity in forcing your member base into one or a few price points, the latter may not offset the opportunities left on the table or lost to national issuers. Based on the limited sample size depicted above, many of the larger credit unions seem to be leveraging pricing strategies effectively today with an APR range of 700 basis points on fixed priced portfolios versus only 500 basis points on variable priced portfolios. However, the national bank issuers still tend to have APR ranges of 1000 basis points, reflecting their focus on more wide ranging risk-based pricing.
Awareness — Another factor in effectively pricing a credit union portfolio involves maintaining an awareness of pricing in totality. Many variably priced issuers claim they don’t have any fixed priced assets within their portfolio. This statement is inaccurate as certain types of balances should be considered fixed whether for the medium to long term; these assets include balance transfers, intro rates, teaser rates, and other promotional APRs. Some institutions even look at transacting (i.e., non-revolving balances) as fixed priced. Theoretically, transacting balances are fixed priced at 0% and rate movements directly impact their profitability. Additional considerations for these programs arise — prior to, during, and after the offering — as the issuer must consider if it can mitigate the challenges of:
- Absorbing the short to medium term funding risk
- Balancing program costs to short-term revenues being driven
- Analysis and comfort around long term payoffs
- Differences in risk behaviors by segments targeted by these products
Are the risks of issuing fixed priced unsecured credit card loans offset by the opportunities? There are a number of powerful benefits that may be uncovered if managed properly. A balanced approach may include the following benefits:
- Fixed priced cards with competitive low rates and simplified fee structures should hit the sweet spot for members looking to use a credit card as a loan product. This opportunity often gets overlooked with the credit card industry’s focus on rewards, benefits, and niche products.
- A financial institution may find that a fixed priced card product is easier to manage and rational to offer if servicing a similar, relatively homogenous population base. This represents a potentially highly effective and targeted credit card strategy.
- Higher rate fixed priced credit card products can be leveraged to serve riskier populations. Additionally many cardmembers have shown the appetite to take on higher APRs in exchange for a program that drives a higher value proposition around rewards.
- Simplicity and security to the cardmember.
In the current economic environment, with stable funding rates, there is likely a low sense of urgency pertaining to taking corrective actions. If something is working today, there exists little motivation to think about alternatives. However, things can change quickly. Recent rate upticks caused a ripple effect and have reflected a sense of what is to come. Financial institutions should prepare for likely future scenarios including how to minimize risk in the future. For those sitting on fixed price portfolios, profitability margins realized today will quickly dissipate with future rate increases. Taking a reactive, rather than proactive stance, could prove to be the riskiest approach of all.Elan Financial Services is one of America’s oldest and largest agent credit card providers for credit unions. For more than 46 years, Elan has delivered a proven partner-based solution, offering best-in-class products and unwavering commitment to service to credit unions across the United States. Elan’s base of more than 2,000 employees is dedicated to helping credit union clients reduce costs and risks associated with managing and growing their credit card portfolios. For more information, call us at 1-800-223-7009 or visit www.cupartnerships.com.