Credit Card Pricing Strategy

Davide Capodici, Brooke Chang, Brian Feldman, Erica Gluck

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

Table of Contents1. Analysis of Industry Structure2. Industry Background3. Competitive Landscape4. First Degree Price Discrimination: FICO Score5. Second Degree Price Discrimination: Types of Cards6. Privacy Issues7. Case Study8. 2011: What's Happening with Credit Cards9. 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 

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.

CREDIT CARD PROCESSING AND MONEY

TRANSFERRING

Establishments in this industry engage in financial transaction processing. They provide the actual payments systems used when payments are made by credit card.

VS.

CREDIT CARD PROCESSING AND

MONEY TRANSFERRING  

VS.

WHAT ARE WE ANALYZING?

CREDIT CARD ISSUING

Our Focus: CREDIT CARD ISSUING

INDUSTRY

A brief introduction to two basic External Drivers

 Use ofCredit Cards   =

f ( DISPOSABLE INCOME) , + 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 - 2011RESULTS: •  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 2011AFTER 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 2011-2016

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 Bank2.The issuing bank sends $98 to the merchant's bank,

and keeps $2: THIS IS THE INTERCHANGE FEE3.The merchant's bank keep other $0.50 as its

PROCESSING FEE4....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 LANDSCAPEWe will focus on:1. MARKET CONCENTRATION2. COMPETITION3. REGULATION4. INDUSTRY ASSISTANCE

  To infer what is the nature of the BARRIERS TO ENTRY  

COMPETITIVE LANDSCAPE1.  MARKET SHARE CONCENTRATION: high and increasing Q: Who are the most  important players?A: IBISWORLD finds for 2011 these market shares:  

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

 

COMPETITIVE LANDSCAPE1.  MARKET SHARE CONCENTRATION: high and increasing Q: Who are the most  important players?A: IBISWORLD finds for 2011 these market shares:   

COMPETITIVE LANDSCAPE1.  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 LANDSCAPE2.  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 LANDSCAPE2.  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 LANDSCAPE3.  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 LANDSCAPE4.  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: HIGH2. Competition: HIGH3. Regulation: HEAVY4. 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 historyo Age of Accounto Debto Available Credito Payment history (on time or late)

• Determine risk factor by looking at various metrics:o Debt-credit ratioo Average account ageo 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 Januaryo 12% APR (~1% per month)o $50 paid off of January statemento $1000 principle remaining on February statemento Feb. balance = $1000 principle + $10 interest

Other Types of Issued 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 lineso Each purchase is a

"mini-loan" from AmEx

o Spending ability is determined by history and FICO score

American Express Charge Cards

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 timeo 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 checkso 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 Expresso Green Card -- basic, lowest fee $95o Gold Card -- entertainment benefits, medium fee

$125o 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 18-26o Adults aged 26-30o Senior citizens over 60o 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 Grocerieso Entertainmento Gaso 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. CitiesDOLS 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

1. CHICAGO 2. BOSTON 3. DALLAS 4. NEW YORK 5. SAN FRANCISCO6. PHILADELPHIA7. LOS ANGELES8. DETROIT 9. WASHINGTON,DC10. HOUSTON11. CHARLOTTE12. SEATTLE 13. BALTIMORE 14. PHOENIX15. INDIANAPOLIS16. MEMPHIS17. FT MYERS18. MILWAUKEE 19. COLUMBUS,OH 20. AUSTIN21. JACKSONVILLE 22. SAN ANTONIO 23. EL PASO 24. SAN DIEGO

1. SAN FRANCISCO2. DALLAS3. LOS ANGELES 4. CHICAGO 5. NEW YORK 6. WASHINGTON,DC7. SEATTLE 8. BOSTON9. HOUSTON10. PHILADELPHIA11. PHOENIX12. SAN DIEGO13. DETROIT14. MILWAUKEE15. SAN ANTONIO16. BALTIMORE17. COLUMBUS,OH18. INDIANAPOLIS19. AUSTIN20. MEMPHIS21. JACKSONVILLE22. CHARLOTTE23. EL PASO24. FT MYERS

2006 2010

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"

Post-Credit Crisis Advertisement

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

MasterCard AdvertisementsPre-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&feature=player_embedded

Discover Card Advertisements

Pre-Crisis "What if"

Post-Crisis "Get Cash Back: 

This One's On Me"

Visa AdvertisementsPre-Crisis"Life Takes Visa""Visa. It's everywhere you want to be." 

Post-Crisis"Let's Go"

"More People Go with Visa"

Pre-Crisis: Excessive Consumption; Easy Money.

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

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 2010o Credit Card companies have been struggling to find new

ways to generate revenueo 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)

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economy-changes-1273.php2. http://www.census.gov/newsroom/releases/archives/population/cb07-91.html 3. http://pressroom.discovercard.com/data/articles/

2006/08/24/200608241122300.shtml4. http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2011/04/18/

investopedia51787.DTL5. http://blogs.wsj.com/economics/2011/04/07/consumers-step-up-student-auto-

loans-cut-back-on-credit-cards/6. http://blogs.creditcards.com/2008/10/credit-card-issuers-cut-tv-

advertising.php7. http://blogs.creditcards.com/2011/02/super-bowl-credit-card-commercials.php8. http://www.businessweek.com/ap/financialnews/D9MKBPQ81.htm