Credit Card Pricing Strategy

Davide Capodici, Brooke Chang, Brian Feldman, Erica Gluck

http://www.youtube.com/watch?v=jBaPx3sym0I&feature=player_embedded

Table of Contents
1. Analysis of Industry Structure 2. Industry Background 3. Competitive Landscape 4. First Degree Price Discrimination: FICO Score 5. Second Degree Price Discrimination: Types of Cards 6. Privacy Issues 7. Case Study 8. 2011: What's Happening with Credit Cards 9. Bibliography

Why Talk About Plastic?

As more and more purchases are made electronically, less cash physically exchanges hands. Credit cards offer payment security, flexibility, and rewards. Even if you don't have a credit card now, you will likely have one in the future. Understanding how creditors price their cards will allow you to get best possible rate in the future!

ANALYSIS OF INDUSTRY STRUCTURE

WHAT ARE WE ANALYZING?

CREDIT CARD ISSUING VS. CREDIT CARD PROCESSING AND MONEY TRANSFERRING The industry's establishments issue credit cards, provide funds required to purchase goods and services in return for a payment on a full balance basis. Establishments in this industry engage in financial transaction processing. They provide the actual payments systems used when payments are made by credit card.

WHAT ARE WE ANALYZING?

CREDIT CARD ISSUING CREDIT CARD PROCESSING AND VS. MONEY TRANSFERRING

Our Focus: CREDIT CARD ISSUING INDUSTRY

A brief introduction to two basic External Drivers

f ( DISPOSABLE INCOME) , + Use of Credit Cards = f ( NATIONAL UNEMPLOYMENT RATE) , If Disposal Income then DISCRETIONARY EXPENDITURE making people more willing to spend money If National Unemployment Rate then DELINQUENCY RATE damaging the lenders

INDUSTRY IN 2006 - 2011

REVENUE: $ 48.3 bn PROFIT: $3.2 bn ---> Profit to Revenue Ratio = 6.67%
..... it's not high! Why? Let's explain it through the external drivers!

INDUSTRY IN 2006 - 2011

2008 CRISIS, brings RECESSION LOW Disposable Income HIGH Unemployment Rate both pushes towards a DECREASE in the use of credit cards

INDUSTRY IN 2006 - 2011

RESULTS:
EROSION OF PROFITS FOR 28% in the overall industry

MERGERS AND ACQUISITION ACTIVITY: The Government aids the most profitable and big players to take over the smallest, in order to avoid their bankruptcy e.g. - Bank of America's Acquisition of Merrill Lynch (2008) - JP Morgan Chase's acquisition of Washington Mutual (2008) and Bear Stearns (2008)

INDUSTRY AFTER 2011

AFTER 2011 ECONOMY IS EXPECTED TO RECOVER: LOWER UNEMPLOYMENT RATE INCREASING DISCRETIONARY EXPENDITURE + RISE OF ONLINE COMMERCE, more money spent through credit cards

INDUSTRY AFTER 2011

RESULTING IN:

EXPECTED GROWTH IN REVENUES OF 5.8% for years 2011-2016 EXPECTED GROWTH IN PROFITS OF 1.3% for years 20112016

HOW DO FIRMS MAKE MONEY?

CREDIT CARD ISSUING FIRMS ONLY OFFER ONE KIND OF PRODUCTS: i.e. CREDIT CARDS .....
...HOWEVER THERE ARE THREE DRIVERS IN GENERATING REVENUES:

HOW DO FIRMS MAKE MONEY?

1) CARDHOLDER FEE: it is an annual fee that customers incur for being able to access credit conveniently through credit cards once it accounted for 40% of revenues (IBISWorld) now it is slowly being eliminated because of intensified competition

HOW DO FIRMS MAKE MONEY?

2) INTEREST INCOME: generated through the debt associated on a credit card which accumulates over time.

in 2011 the interest rate was 12% - 19% and generated 20% of the total industry revenues (IBISWorld)
However, it is risky: 1) it may be never be paid back if the borrower fails (as happened in 2008) 2) if the cardholder pays his balance in full every month there will be no interest income

HOW DO FIRMS MAKE MONEY?

3) INTERCHANGE FEE: HOW DOES IT WORK? 1.Customer purchases a good for $100 and sends the order to the Issuing Bank 2.The issuing bank sends $98 to the merchant's bank, and keeps $2: THIS IS THE INTERCHANGE FEE 3.The merchant's bank keep other $0.50 as its PROCESSING FEE 4....so the merchant gets $97.50 instead of $100.

HOW DO FIRMS MAKE MONEY?

3) INTERCHANGE FEE: fee charged by a bank to process credit and debit transaction made on cards from another bank.

HOW DO FIRMS MAKE MONEY?

....why does he accept this?
The above mentioned trends are a good explanation: the Credit Cards Issuers are increasing their power, especially with the raise of e-Commerce. Merchants are aware that not accepting credit cards would result in a decrease in their sales, so they accept to pay the fee.

WHAT ARE THE COSTS INVOLVED?

WHAT ARE THE COSTS INVOLVED?

1. INTEREST EXPENSES: banks borrow money from other banks at an interbank rate, and then borrow to customers for a higher rate. - IBISWorld estimates these costs to account for 20% of total industry revenue

WHAT ARE THE COSTS INVOLVED?

2. PROVISION FOR LOAN LOSSES: for the reason stated before, some customers may never pay their debt back. This expense accounts for 35% of the overall industry revenues!

WHAT ARE THE COSTS INVOLVED?

3. WAGES: this industry is labor intensive, it is especially true when analyzing customers' credit worthiness: human beings are better than software. Wages accounts for 5.1% of the total revenues

WHAT ARE THE COSTS INVOLVED?

4. ADVERTISING: as we analyzed in class this is COMBATIVE advertising. Q: WHY? LIFE CYCLE OF THE INDUSTRY IS MATURE, so there are not many more customers to reach
(IBISWorld estimates more than 83% of households have one or more credit cards in 2011)

Q: OK, IT'S COMBATIVE...AND SO? Advertising shifts consumer preferences towards the advertising firm, WITHOUT EXPANDING the category demand.

WHAT ARE THE COSTS INVOLVED?

4. ADVERTISING: Q: AND HOW DOES IT LINK TO WHAT YOU SAID BEFORE? It's interesting to say that, since concentration is in act in the industry through Mass, we expect the combative advertising to increase after 2011. In 2011 it accounts for 7.6%

WHAT ARE THE COSTS INVOLVED?

5. REWARDS: according to ComScore, 1/3 of the customers choose their credit cards in order to maximize their rewards. so, rewards (e.g. frequent flier, cash back..) are extremely important to get customers' loyalty and they also ALLOW SECOND DEGREE PRICE DISCRIMINATION. They account for 18% of the total revenues in the industry.

WHAT ARE THE COSTS INVOLVED?

6. OTHERS: e.g. administrative, telecommunications They as a whole account for 5.6% of total revenues. All expenses from 1. to 6. amount 93.3%, so the profits are 100% - 93.3%= 6.7% as stated before.

COMPETITIVE LANDSCAPE
We will focus on: 1. MARKET CONCENTRATION 2. COMPETITION 3. REGULATION 4. INDUSTRY ASSISTANCE
To infer what is the nature of the BARRIERS TO ENTRY

COMPETITIVE LANDSCAPE
1. MARKET SHARE CONCENTRATION: high and increasing

Q: Who are the most important players? A: IBISWORLD finds for 2011 these market shares:
o o o o o

JP MORGAN CHASE: 27.2% BANK OF AMERICA: 19.2% CITIGROUP: 18.9% AMERICAN EXPRESS: 17.2% CAPITAL ONE: 4%

COMPETITIVE LANDSCAPE
1. MARKET SHARE CONCENTRATION: high and increasing

Q: Who are the most important players? A: IBISWORLD finds for 2011 these market shares:

COMPETITIVE LANDSCAPE
1. MARKET SHARE CONCENTRATION: high and increasing

CR4 RATIO= 82.5%

HHI RATIO= 1778, extremely high!

Q: but why does the Government allow M&As? A: it is a different case compared to what we analyzed in class!! A failure in one of these biggest banks can result into the customers losing all their savings, the Government decided to save who was "too big to fail".

COMPETITIVE LANDSCAPE
2. COMPETITION: high

External: there are substitute services, e.g. debit cards, personal checks or cash.
Internal: according to a 2008 AITE Group survey, the most important things for a customer are

NO ANNUAL FEE REWARDS LOW INTEREST RATES

COMPETITIVE LANDSCAPE
2. COMPETITION: high

This leads to a HIGH customers' ELASTICITY OF DEMAND: leading firms compete on those elements, AS FAR AS ANNUAL FEE (which recently represented 40% of the revenue) is projected to disappear in the next few years according to IBISWorld.

COMPETITIVE LANDSCAPE
3. REGULATION: heavy

Bank Holding Company Act of 1968 imposes strict

capital requirements to banks, especially if they are exposed to higher risks.

Truth in Lending Act of 1968 + Schumer Box are

designed to protect customers through higher transparency of conditions

all credit cards need to use the same format in order to

make comparisons easier for customers

COMPETITIVE LANDSCAPE
4. INDUSTRY ASSISTENCE: high

TROUBLED ASSET RELIEF PROGRAM (TARP):

as we discussed before, the "too big to fail" financial institutions have been helped by the Government, to soften the effects of 2008 recession.

HOW? The Government bought their assets and equities for a total of $700 bn! e.g. Citigroup received $45 bn JP Morgan Chase received $25 bn

COMPETITIVE LANDSCAPE
....so: WHAT DO WE INFER ABOUT THE BARRIERS OF ENTRY?
1. Concentration: HIGH 2. Competition: HIGH 3. Regulation: HEAVY 4. Assistance: HIGH

Moreover, consider the 5. Life Cycle Stage: MATURE

---> the barriers to entry are really HIGH in this industry!

Pricing Strategies
First Degree Price Discrimination

How The Industry Works

Credit agencies keep track of consumer credit history.
Banks originate credit lines and determine terms.
Banks lend consumers lines of credit Fixed amount of money based primarily on income and FICO score Terms, including interest rates, are determined based on FICO score

Credit Agencies
Credit agencies such as Experian, TransUnion, and Equifax collect information about consumers Tied to social security number Collect data on: o Account history o Age of Account o Debt o Available Credit o Payment history (on time or late) Determine risk factor by looking at various metrics: o Debt-credit ratio o Average account age o Accounts 30 days, 60 days, and 90 days late.

Credit Card Issuing Banks

Banks around the country underwrite the credit for each credit card. Think of credit card as a mini-loan with terms that "revolve" around the consumer's use of it. Banks finance credit lines with other depositor's funds, much like a mortgage or car loan. Banks earn fees by charging interest on credit card balances that are not paid in full each month. Ex. o $1050 in charges during January o 12% APR (~1% per month) o $50 paid off of January statement o $1000 principle remaining on February statement o Feb. balance = $1000 principle + $10 interest

Other Types of Issued Cards American Express Charge Cards

These cards differ from credit cards in that they must be paid in full each month -- no APR, membership fees. There are no credit lines o Each purchase is a "mini-loan" from AmEx o Spending ability is determined by history and FICO score

Understanding the FICO Score

Understanding the FICO Score, Con't

Scores range between 300-850, high to low risk Payment history 35% -- late payments hurt, on time is good Credit utilization 30% -- ratio of balances to total credit Length of history 15% -- older accounts show experience Types of credit used 10% -- CCs, mortgage, etc. show exp. Search for credit 10% -- each time an application for credit is submitted, an inquiry is made to the report. Inquiries stay on report for 2 years. More inquiries can hurt score, less can improve.

Terms are dictated by FICO score. Better score means lower APRs, reduced fees, etc.

First Degree Pricing Using FICO Score

FICO scores provide a snapshot of the consumer's credit worthiness, and companies price on an individual basis Less risky consumers are worth more in the long run o More responsible spending, payments on time o Have the option of going to other creditors Consumers with good credit scores are desired by the credit issuance industry Offer lower APRs, better terms to attract consumers High risk consumers are less desirable, but can be highly profitable. o Higher risk means higher APRs, worse terms for consumer

First Degree and FICO Con't

FICO scores allow companies to extract the consumer's entire willingness to pay for credit All history is on the table for both parties to see Good for the industry--allows companies to minimize risk using a consistent and relatively low cost method. Using FICO scores is one of the least expensive ways to determine credit worthiness. o Background checks o In the past, lenders might visit a potential client at home, work, or school to get a gauge of their trustworthiness. o FICO scores save time, money, and promote consistency

Second Degree Price Discrimination

Consumers Choose Different Cards Based on Preferences

Second Degree Price Discrimination

Firms are aware that different kinds of customers exist, but they not always can perfectly price discriminate,

Firms know each card user is different, and therefore offer cards with different benefits and associated fees (menu pricing) in order to have customers self selecting. Cards function identically as forms of payment

Second Degree Price Discrimination

Ex. American Express o Green Card -- basic, lowest fee $95 o Gold Card -- entertainment benefits, medium fee $125 o Platinum Card -- numerous benefits, high fee $450

Segmenting the Market

The market can easily be segmented into four major categories (IBISWorld): o Young adults aged 18-26 o Adults aged 26-30 o Senior citizens over 60 o Businesses JP Morgan, industry leader, offers credit to these groups in different ways with a "menu-pricing" like strategy We will analyze the first two segments as an example.

Young Adults - Freedom Card

Less credit history/experience Cards with few-no frills Small credit lines Cash back as incentive Extra cash, or points for paying on time Usually no extra membership fees or annual charges

5% cash back on up to $1500 in particular categories If only $1499, reward is 1%.

Absorbs consumer surplus

Adults aged 26-60

Uses cards more regularly for everything: o Groceries o Entertainment o Gas o Luxury goods

Users look for rewards programs, usually offered for an annual fee

Value of rewards only exceeds fee if card is used enough, arousing consumers loyalty
Given the cost of maintaining the programs, these cards are generally reserved for users with better credit

Case Study in Credit Card Advertisements

Privacy Laws
- The Fair Credit Reporting Act promotes the accuracy, fairness, and privacy of personal information by Credit Reporting Agencies - The Gramm-Leach-Bliley Act (1999) protects personal information collected by financial institutions from foreseeable threats in security and data integrity.

Gramm-Leach-Bliley Act
- components govern the collection, disclosure and protection of consumers' nonpublic personal information: The Financial Privacy Rule: requires financial institutions to provide each consumer with a privacy notice when a consumer relationship is established Safeguards Rule: requires financial institutions to devise a written info security plan stating their preparation and continuing plans of protecting clients' nonpublic personal info

http://business.ftc.gov/privacy-and-security/credit-reports

Pre-Credit Crisis vs. Post Credit-Crisis

What we will be looking at:
2006 vs. 2010 credit card advertising data in 24 of the largest U.S. cities How the advertisements changed with the economy

Advertising on different levels of credit cards in 2006 vs. 2010

24 Most Populous U.S. Cities DOLS Spent on Advertising Per City 2006 vs. 2010

DOLS

*These were the top 25 most populous cities in the U.S. in 2006. San Jose was removed from the list because we did not have the data for it, so all of the cities are ranked 1-25. The population information is from the U.S. Census Bureau.

Advertising Rank - 24 US Cities

2006
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. CHICAGO BOSTON DALLAS NEW YORK SAN FRANCISCO PHILADELPHIA LOS ANGELES DETROIT WASHINGTON,DC HOUSTON CHARLOTTE SEATTLE BALTIMORE PHOENIX INDIANAPOLIS MEMPHIS FT MYERS MILWAUKEE COLUMBUS,OH AUSTIN JACKSONVILLE SAN ANTONIO EL PASO SAN DIEGO

2010
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. SAN FRANCISCO DALLAS LOS ANGELES CHICAGO NEW YORK WASHINGTON,DC SEATTLE BOSTON HOUSTON PHILADELPHIA PHOENIX SAN DIEGO DETROIT MILWAUKEE SAN ANTONIO BALTIMORE COLUMBUS,OH INDIANAPOLIS AUSTIN MEMPHIS JACKSONVILLE CHARLOTTE EL PASO FT MYERS

By the Numbers

Scaling Back Advertisements after the Crisis

American Express Advertisements

Pre-Crisis "Membership Has Its Privileges"

Post-Crisis "Don't Take Chances, Take Charge"

http://www.youtube.com/watch?v=qWhh78JLSIY&fe ature=player_embedded

Post-Credit Crisis Advertisement

MasterCard Advertisements
Pre-Crisis "There are some things money can't buy. For everything else, there's MasterCard" Post-Crisis "There are some things money can't buy. For everything else, there's MasterCard" Discounts on various items offered on MasterCard's home page

http://www.youtube.com/watch?v=yNMD70M91GA&f eature=player_embedded

Discover Card Advertisements

Pre-Crisis "What if"

Post-Crisis "Get Cash Back: This One's On Me"

Visa Advertisements
Pre-Crisis "Life Takes Visa" "Visa. It's everywhere you want to be."
Post-Crisis "Let's Go" "More People Go with Visa"

http://www.youtube.com/watch?v=Xy_PxLw1B_c&feat ure=player_embedded

Pre-Crisis: Excessive Consumption; Easy Money.

Trends in Amex Card Advertisements

Amex Cards, cont.'d

In 2006- $30,649,266 spent on American Express Blue Card Ads In 2010- $21,528,612 spent on American Express Zync Card Ads

Conclusions About Credit Card Television Advertisements Before and After the Credit Crisis
Advertisements were more expensive before Encouraged wilder spending habits o Evidenced by the changed advertisements and slogans Fewer advertisements in 2006 vs. 2010 TV Ads were about half the price in 2010 Less money was spent on advertisements Ads promised more rewards Less emphasis on careless spending

What's Happening Now?

2011: Credit Cards in the News

Revolving credit, or credit-card use, fell $2.71 billion to $794.03 billion in February (WSJ) The Credit Card Act of 2009 was enacted in February of 2010 o Credit Card companies have been struggling to find new ways to generate revenue o Laws protect students and others from unnecessary fees and bad credit Chip and Pin cards are starting to roll out in the U.S Late payments and defaults have been declining (Businessweek)

Bibliography
1. http://www.creditcards.com/credit-card-news/advertisements-credit-cardseconomy-changes-1273.php 2. http://www.census.gov/newsroom/releases/archives/population/cb07-91.html 3. http://pressroom.discovercard.com/data/articles/2006/08/24/20060824112230 0.shtml 4. http://www.sfgate.com/cgibin/article.cgi?f=/g/a/2011/04/18/investopedia51787.DTL 5. http://blogs.wsj.com/economics/2011/04/07/consumers-step-up-student-autoloans-cut-back-on-credit-cards/ 6. http://blogs.creditcards.com/2008/10/credit-card-issuers-cut-tv-advertising.php 7. http://blogs.creditcards.com/2011/02/super-bowl-credit-card-commercials.php 8. http://www.businessweek.com/ap/financialnews/D9MKBPQ81.htm