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Contents Whats in the cards? The future of the US payment card system Vijay DSilva, Asheet Mehta, and John Stephenson Electronic bill payment and presentment The options for banks are becoming clear John Ouren, Marc Singer, John Stephenson, and Allen L. Weinberg 90

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Whats in the cards?

The future of the US payment card system
Vijay DSilva, Asheet Mehta, and John Stephenson redit cards are arguably the most successful retail nancial product introduced this century. Just 40 years ater their creation, they are ubiquitous among consumers, indispensable for retailers, and a major money-spinner for the banking sector. Yet the card industry has recently undergone wrenching changes. No doubt about it: though cards continue to displace cash and checks and to capture a growing share of consumer spending, the competitive environment of the future will look dramatically diferent from that of the past. Card issuers must reevaluate their strategies to reect the new challenges and opportunities that lie ahead.

In 1996, the protability of the credit card industry fell below 1.3 percent return on assets (ROA) ater averaging 3.1 percent over the previous four years. Many issuers were caught unawares at a time when the US economy was booming and card revenues, charge volumes, and outstandings (the total balances unpaid by cardholders) were growing at double-digit rates. Protability recovered marginally in 1997 to 1.5 percent ROA, but a number of issuers sufered credit problems, and several leading players (including AT&T, Advanta, and Bank of New York) exited the business. Meanwhile, the mergers of Bank One, First USA, and First Chicago NBD and of NationsBank and BankAmerica are only the most prominent episodes in a wave of consolidation that has transformed what used to be a highly fragmented industry. In 1986, the top 10 issuers controlled just 38 percent of all outstandings; today, they control a full 70 percent. Although issuers will probably face even steeper challenges in the future, opportunities for protable growth remain. Card companies can apply leadingedge marketing and risk management techniques to maximize the protability of their current portfolios. Once this operational excellence is in place, they can leverage it to prot from the restructuring and consolidation of the industry. In addition, they will be able to target new nancial ows outside the consumer-to-business payments that have been the credit cards traditional domain, and exploit new payment-related technologies. The biggest prize will go to the companies that combine these elements to create powerfully attractive payment propositions that ofer both customers and merchants better value than do todays plastic card products.

We wish to thank Philip Bruno and Abhay Joshi for their contributions to this article. Vijay DSilva is a consultant and Jack Stephenson and Asheet Mehta are principals in McKinseys New York office. Copyright 1998 McKinsey & Company. All rights reserved.

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The shakeout Several factors suggest that the dramatic slump in protability in 199697 was more than a hiccup. First, acquisition costs have soared. Penetrating consumers wallets is becoming increasingly dicult at a time when more than 82 percent of US households have credit cards (up from only 56 percent in 1989) and the average household carries four general purpose bank cards and ten special purpose and charge cards. Moreover, many current marketing trends have reached a plateau. Both anity and co-branded cards (such as university aliations and airline cards) are seeing the same response rates as non-co-branded cards. Yet direct mailings are at an all-time high: in 1997, there were upward of three billion solicitations in the United States, or 30 per household. As a result, response rates have plummeted to 1.3 percent, from almost 3 percent in 1992. The average cost of acquiring a new account via direct mail is now well over $100, up from only $40 in 1992. The true cost of gaining and maintaining active accounts is higher still because they constitute a declining share of the whole, having fallen from 74 percent in 1991 to only 58 percent in 1997. Second, revenues are under pressure from increased competition. Issuers have been resorting to massive discounting in net interest margins, primarily through introductory (teaser) rates that in some cases are now as low as 0 percent. Meanwhile, annual fees have fallen by roughly 60 percent since 1991 to less than $4.30 per account. Although issuers have tried to compensate with such hidden charges as higher penalties for late payments and reduced grace periods before which interest starts accruing, these have gone only part of the way. Unfortunately for them, customers are becoming more sensitive to rates and fees, making it dicult to institute increases in the near future.* Perhaps the most worrying of the industrys problems is the decline in credit quality, which for several reasons looks likely to continue. First, despite a period of strong growth in the US economy, delinquencies are now at 5.4 percent, roughly 1.4 times the average of the past ten years. A recession could prove disastrous. Second, the portfolio mix has become considerably riskier, with 17 percent of all outstandings (up from 12 percent in 1989) now held by lower-income households that are ten times more likely than wealthy ones to fall behind in their payments. Third, a slowdown in the growth of outstandings could increase the proportion of delinquencies. The average age

* Annual fees were rare until the beginning of the 1980s, when the Carter administrations credit controls gave issuers an excuse to introduce them almost in unison, as it turned out. This trend lasted for a decade. The distinction of starting the no-fee trend went to AT&T, which entered the market by pleasantly surprising consumers with a no fee for life card. Triggering a wave of competing no-fee cards, it changed the industrys economics and naturally elevated AT&T to the ranks of the top 10 issuers. It also attracted a high proportion of price-sensitive consumers. AT&T eventually decided to exit the business, selling its portfolio to Citicorp in 1997.

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of an account at the time when it is written of is 18 to 24 months, so if outstandings had not increased during the previous two years, the current delinquency rate would have been 1.5 times higher than it actually is. Fourth, issuers have extended their credit lines by 25 percent annually over the past three years to a total of $1.8 trillion as against outstandings of $400 billion, leaving a growing level of hidden liability. Finally, and most disturbing, the level of bankruptcy has soared; almost 1.4 million households an all-time high were estimated to have led for bankruptcy in the 12 months to March 1998. Since this development has been attributed largely to changing attitudes toward bankruptcy among consumers and to easier access to procedures for arranging it, the level of bankruptcy can no longer be predicted in the traditional way, through the unemployment and divorce rates. Given these diculties, small and medium-sized players are feeling strong pressure to leave the industry; as we have seen, the top 10 issuers now hold 70 percent of outstandings. Evidence suggests that the industry will continue to consolidate in the hands of large banks and a few remaining monolines (companies pursuing a single product strategy on a national scale that have redened how the industry competes through their superior execution). Many observers believe that the top 10 issuers may come to hold more than 80 percent of all outstandings in the next ve years. To put it another way, more than a third of the capacity now provided by smaller players will probably vanish. Opportunities Tomorrows competitive environment will undoubtedly be more challenging than ever. Success in the mass-market direct mail and telephone solicitation business will increasingly go to the biggest players. Yet scale alone will not suce: world-class information-based marketing and risk management skills will also be critical. For companies that have the requisite scale and skill, attractive growth opportunities remain.

Operational excellence
Now that they account for 75 percent of all credit card ofers mailed to consumers, the 12 largest issuers can leverage phenomenal quantities of consumer and testing data. Scale helps issuers lock up the best partners, which then help them acquire and retain the best customers. In addition, scale plays an important part in justifying hightechnology expenses and in gaining more cost-efective access to relatively quick funding through the asset-backed securities markets (securities issued to investors that are backed by pools of credit card accounts and receivables).

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As well as scale, issuers will need world-class (and possibly expensive) marketing, micro-segmentation, and risk management skills. Best-practice players already possess sophisticated predictive scoring models created with information gained from hundreds of tests and mailings.* In addition to investing in systems to track them, such companies support thousands of tailored ofers on an ongoing basis. By these and other means, they have given themselves a clear head start over the rest of the eld. Best-practice players price efectively for risk when acquiring accounts, thus signing up the best risks and undercutting rivals that still rely on standard pricing, leaving them with potential selection problems. In addition, the most adroit issuers are paying more attention to sophisticated account management. We estimate that almost 60 percent of ongoing accounts are unprotable on average (Exhibit 1). By using micro-segmentation techniques to divide portfolios into diferent behavioral segments, issuers can take steps to improve their return on unprotable segments. Consider a simple example. Portfolios can be segmented into very heavy revolvers (people who carry large balances on their credit cards which they almost always revolve into the next month the most protable customer segment), heavy revolvers, light revolvers, heavy transactors, light transactors, risky credits, and inactive accounts. Although the last three segments are unprotable, things can be done to improve their yield. For light transactors, usage stimulation programs, balance consolidation, and higher fees may help. Repricing, reducing lines, and increasing late and other fees can be useful for risky credits. As for inactive accounts, issuers can levy annual fees, experiment with activation programs, cancel accounts, and ofer new products and incentives. Taken
Exhibit 1

* Credit cards have reached a level of competitiveness well beyond that of most consumer financial services, and traditional creative marketing, while still important, is giving way to a more rigorous process of finding combinations of price and communications that appeal to very small segments of consumers. A structured testing process is used to investigate how different consumers react to offers of various products, and the ability to interpret and manage that process is becoming indispensable.

Unprofitable accounts
Pretax income per account, $ Average Very heavy revolvers Heavy revolvers Light revolvers Heavy transactors Light transactors Risky credits Inactive Portfolio average 200 35 25 20 59% of accounts 20 50 175 Percent of accounts 450 5 11 15 10 14 4 41

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together, such tactics can have a powerful efect: in one case, halving losses on unprotable accounts boosted a portfolios protability by more than 50 percent. As well as neglecting unprotable accounts, many issuers ignore protable ones that can be made even more lucrative with a little efort. Heavy revolvers can oten be further segmented by payment rates, transaction frequencies, the proportion of their credit limit that they use, the size of their average transactions, and the number of places where they use their card. A targeted program can stimulate additional transactions among cardholders with low payment rates, few transactions, and low line utilization. For cardholders with high payment rates, small transactions, and numerous transactions every month, a nely tuned program (created with the aid of such techniques as lifecycle analysis) can increase the proportion of big ticket sales.

Industry consolidation
Issuers that have achieved operational excellence can take advantage of opportunities to prot from the industrys consolidation. In 1997, card portfolio sales reached an unprecedented $30 billion. Much of this no doubt resulted from such headline-grabbing deals as those between AT&T and Citibank and between First USA, Bank One, and First Chicago NBD. Yet this activity may have diverted attention from an underlying fact: many card issuers lack sophisticated marketing and risk management skills and thus cannot increase the size of their portfolios protably. Unable to compete efectively, they may be inclined to exit the business by selling their portfolios outright, selling of nonstrategic accounts, or private-labeling their portfolios to another issuer (oten referred to as white-labeling). Such developments create a range of growth opportunities: Acquiring and xing portfolios. As issuers seek to leave the industry, portfolios will come up for sale. Although many companies can price them by rigorously analyzing their current and potential protability, only players that can stimulate and retain usage adeptly will succeed in creating value and turning around poorly performing portfolios. These players will also be able to use their superior underwriting skills to price adequately for risk. Private and white labels. Another opportunity for skilled players involves providing white- and private-label programs for banks and retailers that wish to maintain card relationships with customers without spending more money courting them or increasing the level of risk incurred on their behalf. Renting services and outsourcing. Finally, skilled players can rent elements of their business systems by applying their underwriting, pricing, or usage stimulation skills to the portfolios of other issuers, who continue to acquire, bill,

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service, and collect their portfolios. Capital One is already pursuing this strategy. Others are certain to follow.

New sources of growth

Credit cards have been used primarily for consumer-tobusiness payments. Today, they capture roughly 22 percent of ows and 19 percent of transactions in the United States. As merchants in such relatively untapped categories as grocery stores, service stations, utilities, and pharmacies become more willing to accept credit cards, issuers will have opportunities to tailor new oferings that enhance consumer value.
Exhibit 2

Structure of transactions and flows

Transactions, $ million Total: $648,189 million From 3,104

Consumers

6,441 Business* Government

589,602 32,220 3,567 4,951

6,043

2,163

90

To

Consumers

Business

Government

Flows, $ billion Total: $21,573 billion From Consumers

72 5,363

1,106

Business*

8,164 2,949

1,193

Government

1,769

505

452

Increased penetration in several areas will also fuel growth in the number of credit cards. These areas include consumer-toconsumer ows (money transfers, gits, loans, payments to children), business-to-consumer ows (disbursements to employees, marketing promotions, eet cards), government-to-consumer ows (electronic benets transfers), business-tobusiness ows (corporate purchasing, travel and entertainment cards), consumer-to-government ows (taxes, licence and user fees, parking tickets), and businessto-government ows (government services, licences, user fees). Collectively, these represent the lions share of total payment ows but are still relatively underpenetrated, creating opportunities for issuers to introduce value propositions that build on them (Exhibit 2). Other possibilities for growth come from international markets

To

Consumers

Business

Government

* Excludes large-dollar fund-clearing flows

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both developed countries such as Germany and many emerging markets, which have been growing at levels ranging from 21 to 95 percent. Many of these countries have penetration rates that are less than a tenth of the US level. Our projections suggest that international spending will represent 61 percent of total bank card spending by the year 2005, up from 54 percent in 1995 (Exhibit 3).
Exhibit 3

The international opportunity

Total bank card spending, $ million Credit card volume in 1995 Growth in US market Growth in foreign market Estimated credit card volume in 2005 39% 61% 46% 54% 1,246 1,626 2,713 5,585
United States Rest of world

Technological innovation
The convergence of powerful technologies will eventually drive a wave of innovation that dramatically increases the overall value proposition of credit cards. These technologies include cards with microchips and stored-value magnetic strips, multi-application operating systems, scaleable processing, intelligent agents, and improved analytical tools based on neural networks. Cards of various kinds will be used by consumers to access a host of services, and by issuers to drive a new wave of product innovation. By helping to identify consumers, for example, cards can verify, authorize, and authenticate transactions using a range of access devices, including point-of-sale terminals, automatic teller machines, wireless phones, personal computers, set-top boxes, and personal digital assistants. The services they access could include not only the full range of nancial services but also e-commerce, health care, and government, education, and information services. Meanwhile, payment networks will become much richer sources of information, allowing issuers to analyze their customer transaction data far more minutely than they currently do to deliver true segment-of-one ofers. Rewards and discounts will be tailored to the way consumers actually shop and use their cards. Issuers that have multiple card relationships with customers and their immediate families will use information technology to create linked suites of card products. These oferings will give customers much greater control over their accounts (for instance, the opportunity to have multiple subaccounts for various purposes), richer information (such as billing details in any format they desire), convenience, and value (including reward programs linking multiple cards and accounts).

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Banking on the future Powered by superior skills in such areas as micromarketing, risk management, servicing, and collection, focused specialists including MBNA, First USA, Capital One, and Providian continue to gain market share. Yet banks that can improve their skills still enjoy opportunities of their own, since many of them maintain broad consumer franchises with a variety of products. Banks can, for example, move away from separate P&Ls to manage the lifetime value of consumers holistically across credit cards, debit cards, checking and savings accounts, automatic teller machines, lines of credit, and investment accounts. This would permit them to ofer consumers compelling bundles that monolines would be hard pressed to match. Finally, banks still hold a dominant 90 to 95 percent share of the cash, automatic teller machine, check, and debit card businesses that collectively account for more than 75 percent of the consumer payment wallet. This position of strategic strength means those that develop coherent payment strategies will enjoy a substantial competitive advantage. Paradoxically for the credit card industry, those banks that start viewing cards as just one payment mechanism within an overall value proposition will probably emerge as the winners.

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