Credit Card Pricing Strategy

1. Credit Card Pricing Strategy Davide Capodici, Brooke Chang, Brian Feldman, Erica Gluck

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

3. Table of Contents • Analysis of Industry Structure • Industry Background • Competitive Landscape • First Degree Price Discrimination: FICO Score • Second Degree Price Discrimination: Types of Cards • Privacy Issues • Case Study • 2011: What's Happening with Credit Cards • Bibliography

4. 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!

5.  ANALYSIS OF INDUSTRY STRUCTURE

6. 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. WHAT ARE WE ANALYZING? VS.

7. CREDIT CARD PROCESSING AND MONEY TRANSFERRING WHAT ARE WE ANALYZING? CREDIT CARD ISSUING VS.

8. Our Focus: CREDIT CARD ISSUING INDUSTRY

9. Use ofCredit Cards   = f ( DISPOSABLE INCOME) , + f ( NATIONAL UNEMPLOYMENT RATE) , - A brief introduction to two basic External Drivers • If Disposal Income   then DISCRETIONARY             •                                           EXPENDITURE  •      making people more willing to spend money •  If National Unemployment Rate       •       then DELINQUENCY RATE     damaging the lenders

10. 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!

11. 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

12. 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) 

13. 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

14. 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

15. 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:

16. 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

17. 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

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

19. 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.

20. 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.

21. WHAT ARE THE COSTS INVOLVED?

22. WHAT ARE THE COSTS INVOLVED? • 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

23. 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!

24. 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

25. 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.             

26. 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%

27. 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.

28. 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.

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

30. COMPETITIVE LANDSCAPE 1.  MARKET SHARE CONCENTRATION: high and increasing Q: Who are the most  important players? A: IBISWORLD finds for 2011 these market shares:  • JP MORGAN CHASE: 27.2% • BANK OF AMERICA: 19.2% • CITIGROUP: 18.9% • AMERICAN EXPRESS: 17.2% • CAPITAL ONE: 4%

31. COMPETITIVE LANDSCAPE 1.  MARKET SHARE CONCENTRATION: high and increasing Q: Who are the most  important players? A: IBISWORLD finds for 2011 these market shares: 

32. 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".

33. 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

34. 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.

35. 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

36. 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

37. COMPETITIVE LANDSCAPE ....so:  WHAT DO WE INFER ABOUT THE BARRIERS OF            ENTRY? • Concentration: HIGH • Competition: HIGH • Regulation: HEAVY • Assistance: HIGH Moreover, consider the 5. Life Cycle Stage: MATURE ---> the barriers to entry are really HIGH in this industry!

38. Pricing Strategies First Degree Price Discrimination

39. 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 How The Industry Works

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

41. 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.  • $1050 in charges during January • 12% APR (~1% per month) • $50 paid off of January statement • $1000 principle remaining on February statement • Feb. balance = $1000 principle + $10 interest

42. 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 • Each purchase is a "mini-loan" from AmEx • Spending ability is determined by history and FICO score

43. Understanding the FICO Score

44. 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.  

45. 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 • More responsible spending, payments on time • 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. • Higher risk means higher APRs, worse terms for consumer

46. 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. • Background checks • In the past, lenders might visit a potential client at home, work, or school to get a gauge of their trustworthiness. • FICO scores save time, money, and promote consistency

47. Second Degree Price Discrimination Consumers Choose Different Cards Based on Preferences

48. 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

49. Second Degree Price Discrimination • Ex. American Express • Green Card -- basic, lowest fee $95 • Gold Card -- entertainment benefits, medium fee $125 • Platinum Card -- numerous benefits, high fee $450

50. Segmenting the Market • The market can easily be segmented into four major categories (IBISWorld): • Young adults aged 18-26 • Adults aged 26-30 • Senior citizens over 60 • 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.