what’s in the cards

Contents

What’s in the cards? 90The future of the US payment card systemVijay D’Silva, Asheet Mehta, and John Stephenson

Electronic bill payment and presentment 98The options for banks are becoming clearJohn Ouren, Marc Singer, John Stephenson, and Allen L. Weinberg

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What’s in the cards?The future of the US payment card system

Credit cards are arguably the most successful retailfinancial product introduced this century. Just 40 years aƒter their creation, they are ubiquitous

among consumers, indispensable for retailers, and amajor money-spinner for the banking sector. Yet the cardindustry has recently undergone wrenching changes. Nodoubt about it: though cards continue to displace cashand checks and to capture a growing share of consumerspending, the competitive environment of the future willlook dramatically diƒferent from that of the past. Cardissuers must reevaluate their strategies to reflect the newchallenges and opportunities that lie ahead.

In 1996, the profitability of the credit card industry fellbelow 1.3 percent return on assets (ROA) aƒter averaging3.1 percent over the previous four years. Many issuerswere caught unawares at a time when the US economywas booming and card revenues, charge volumes, andoutstandings (the total balances unpaid by cardholders)were growing at double-digit rates. Profitabilityrecovered marginally in 1997 to 1.5 percent ROA, but anumber of issuers suƒfered credit problems, and severalleading players (including AT&T, Advanta, and Bank of New York) exited the business. Meanwhile, themergers of Bank One, First USA, and First ChicagoNBD and of NationsBank and BankAmerica are onlythe most prominent episodes in a wave of consolidationthat has transformed what used to be a highlyfragmented industry. In 1986, the top 10 issuerscontrolled just 38 percent of all outstandings; today, they control a full 70 percent.

Although issuers will probably face even steeperchallenges in the future, opportunities for profitablegrowth remain. Card companies can apply leading-edge marketing and risk management techniques tomaximize the profitability of their current portfolios.Once this operational excellence is in place, they can leverage it to profit from the restructuring andconsolidation of the industry. In addition, they will be able to target new financial flows outside theconsumer-to-business payments that have been thecredit card’s traditional domain, and exploit newpayment-related technologies. The biggest prize willgo to the companies that combine these elements tocreate powerfully attractive payment propositionsthat oƒfer both customers and merchants better value than do today’s plastic card products.

Vijay D’Silva, Asheet Mehta, andJohn Stephenson

90 THE McKINSEY QUARTERLY 1998 NUMBER 4


We wish to thank Philip Bruno

and Abhay Joshi for their

contributions to this article.

Vijay D’Silva is a consultant and

Jack Stephenson and Asheet

Mehta are principals in

McKinsey’s New York office.

Copyright © 1998 McKinsey &

Company. All rights reserved.

The shakeoutSeveral factors suggest that the dramatic slump inprofitability in 1996–97 was more than a hiccup. First,acquisition costs have soared. Penetrating consumers’wallets is becoming increasingly diƒficult at a time whenmore than 82 percent of US households have credit cards (up from only 56 percent in 1989) and the averagehousehold carries four general purpose bank cards and ten special purpose and charge cards.

Moreover, many current marketing trends have reached a plateau. Both aƒfinity and co-branded cards (such asuniversity aƒfiliations and airline cards) are seeing the same response rates as non-co-branded cards. Yet directmailings are at an all-time high: in 1997, there were upwardof three billion solicitations in the United States, or 30 perhousehold. As a result, response rates have plummeted to 1.3 percent, from almost 3 percent in 1992. The average costof acquiring a new account via direct mail is now well over$100, up from only $40 in 1992. The “true” cost of gainingand maintaining active accounts is higher still because theyconstitute a declining share of the whole, having fallen from74 percent in 1991 to only 58 percent in 1997.

Second, revenues are under pressure from increasedcompetition. Issuers have been resorting to massivediscounting in net interest margins, primarily throughintroductory (“teaser”) rates that in some cases are now as low as 0 percent. Meanwhile, annual fees have fallen byroughly 60 percent since 1991 to less than $4.30 per account.Although issuers have tried to compensate with such hiddencharges as higher penalties for late payments and reducedgrace periods before which interest starts accruing, thesehave gone only part of the way. Unfortunately for them,customers are becoming more sensitive to rates and fees,making it diƒficult to institute increases in the near future.*

Perhaps the most worrying of the industry’s problems is the decline in credit quality, which for several reasons looks likely to continue. First, despite a period of stronggrowth 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 couldincrease the proportion of delinquencies. The average age

THE McKINSEY QUARTERLY 1998 NUMBER 4 91

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* Annual fees were rare until the

beginning of the 1980s, when

the Carter administration’s

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 industry’s

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.

of an account at the time when it is written oƒf is 18 to 24 months, so if outstandings had not increased during the previous two years, the current delinquency rate wouldhave been 1.5 times higher than it actually is. Fourth, issuers have extended their credit lines by 25 percentannually over the past three years to a total of $1.8 trillion as against outstandings of $400 billion, leaving a growinglevel 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 filed for bankruptcy in the 12 months to March 1998. Since this development has beenattributed largely to changing attitudes toward bankruptcyamong consumers and to easier access to procedures forarranging it, the level of bankruptcy can no longer bepredicted in the traditional way, through the unemploymentand divorce rates.

Given these diƒficulties, small and medium-sized players are feeling strong pressure to leave the industry; as we haveseen, the top 10 issuers now hold 70 percent of outstandings.Evidence suggests that the industry will continue toconsolidate in the hands of large banks and a few remaining“monolines” (companies pursuing a single product strategyon a national scale that have redefined how the industrycompetes through their superior execution). Many observersbelieve that the top 10 issuers may come to hold more than80 percent of all outstandings in the next five years. To put it another way, more than a third of the capacity nowprovided by smaller players will probably vanish.

OpportunitiesTomorrow’s competitive environment will undoubtedly bemore challenging than ever. Success in the mass-marketdirect mail and telephone solicitation business willincreasingly go to the biggest players. Yet scale alone willnot suƒfice: world-class information-based marketing andrisk management skills will also be critical. For companiesthat have the requisite scale and skill, attractive growthopportunities remain.

Operational excellence Now that they account for 75 percent of all credit cardoƒfers mailed to consumers, the 12 largest issuers canleverage phenomenal quantities of consumer and testingdata. Scale helps issuers lock up the best partners, whichthen help them acquire and retain the best customers. Inaddition, scale plays an important part in justifying high-technology expenses and in gaining more cost-eƒfectiveaccess to relatively quick funding through the asset-backedsecurities markets (securities issued to investors that arebacked by pools of credit card accounts and receivables).



As well as scale, issuers will need world-class (and possiblyexpensive) marketing, micro-segmentation, and riskmanagement skills. Best-practice players already possesssophisticated predictive scoring models created withinformation gained from hundreds of tests and mailings.* In addition to investing in systems to track them, suchcompanies support thousands of tailored oƒfers on anongoing basis. By these and other means, they have giventhemselves a clear head start over the rest of the field.

Best-practice players price eƒfectively for risk whenacquiring accounts, thus signing up the best risks andundercutting rivals that still rely on standard pricing, leaving them with potential selection problems. In addition, the most adroit issuers are paying more attentionto sophisticated account management. We estimate thatalmost 60 percent of ongoing accounts are unprofitable on average (Exhibit 1). By using micro-segmentationtechniques to divide portfolios into diƒferent behavioralsegments, issuers can take steps to improve their return on unprofitable segments.

Consider a simple example. Portfolios can be segmentedinto very heavy “revolvers” (people who carry largebalances on their credit cards which they almost always“revolve” into the next month – the most profitablecustomer segment), heavy revolvers, light revolvers, heavy transactors, light transactors, risky credits, andinactive accounts. Although the last three segments areunprofitable, things can be done to improve their yield. For light transactors, usage stimulation programs, balanceconsolidation, and higher fees may help. Repricing, reducinglines, and increasing late and other fees can be useful forrisky credits. As for inactive accounts, issuers can levyannual fees, experiment with activation programs, cancelaccounts, and oƒfer new products and incentives. Taken



* 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.

Exhibit 1

Unprofitable accounts

Very heavy revolvers

Heavy revolvers

Light revolvers

Heavy transactors

Light transactors

Risky credits

Inactive

Portfolio average

Percent of accounts

5

11

15

10

14

4

41

Pretax income per account, $

–200

–35

–20

450

175

20

50

25

59% of accounts

Average ˘

together, such tactics can have a powerful eƒfect: in one case,halving losses on unprofitable accounts boosted a portfolio’sprofitability by more than 50 percent.

As well as neglecting unprofitable accounts, many issuersignore profitable ones that can be made even more lucrativewith a little eƒfort. Heavy revolvers can oƒten be furthersegmented by payment rates, transaction frequencies, theproportion of their credit limit that they use, the size of theiraverage transactions, and the number of places where theyuse their card. A targeted program can stimulate additionaltransactions among cardholders with low payment rates, fewtransactions, and low line utilization. For cardholders withhigh payment rates, small transactions, and numeroustransactions every month, a finely tuned program (createdwith the aid of such techniques as lifecycle analysis) canincrease the proportion of “big ticket” sales.

Industry consolidation Issuers that have achieved operational excellence can takeadvantage of opportunities to profit from the industry’sconsolidation. In 1997, card portfolio sales reached anunprecedented $30 billion. Much of this no doubt resultedfrom such headline-grabbing deals as those between AT&Tand Citibank and between First USA, Bank One, and First Chicago NBD. Yet this activity may have divertedattention from an underlying fact: many card issuers lacksophisticated marketing and risk management skills andthus cannot increase the size of their portfolios profitably.Unable to compete eƒfectively, they may be inclined to exitthe business by selling their portfolios outright, selling oƒfnonstrategic accounts, or private-labeling their portfolios toanother issuer (oƒten referred to as “white-labeling”). Suchdevelopments create a range of growth opportunities:

Acquiring and fixing portfolios. As issuers seek to leavethe industry, portfolios will come up for sale. Although manycompanies can price them by rigorously analyzing theircurrent and potential profitability, only players that canstimulate and retain usage adeptly will succeed in creatingvalue and turning around poorly performing portfolios.These players will also be able to use their superiorunderwriting skills to price adequately for risk.

Private and white labels. Another opportunity for skilled players involves providing white- and private-labelprograms for banks and retailers that wish to maintain cardrelationships with customers without spending more moneycourting them or increasing the level of risk incurred ontheir behalf.

Renting services and outsourcing. Finally, skilled playerscan rent elements of their business systems by applyingtheir underwriting, pricing, or usage stimulation skills to the portfolios of other issuers, who continue to acquire, bill,



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

New sources of growthCredit cards have been used primarily for consumer-to-business payments. Today, they capture roughly 22 percentof flows and 19 percent of transactions in the United States.As merchants in such relatively untapped categories asgrocery stores, service stations, utilities, and pharmaciesbecome more willing to accept credit cards, issuers will have opportunities to tailor new oƒferings that enhanceconsumer value.

Increased penetration inseveral areas will also fuelgrowth in the number ofcredit cards. These areasinclude consumer-to-consumer flows (moneytransfers, giƒts, loans,payments to children),business-to-consumer flows (disbursements toemployees, marketingpromotions, fleet cards),government-to-consumerflows (electronic benefitstransfers), business-to-business flows (corporatepurchasing, travel andentertainment cards),consumer-to-governmentflows (taxes, licence and user fees, parkingtickets), and business-to-government flows(government services,licences, user fees).Collectively, these representthe lion’s share of totalpayment flows but are stillrelatively underpenetrated,creating opportunities forissuers to introduce valuepropositions that build onthem (Exhibit 2).

Other possibilities forgrowth come frominternational markets —



Exhibit 2

Structure of transactions and flows

Consumers

From

To

Business*

Government

˘ Consumers

˘ Business

˘ Government

589,6026,441

6,043

2,163

72

2,9498,164

4,951

3,104

3,567

32,220

90

1,193

4525051,769

5,363

1,106

Flows, $ billion Total: $21,573 billion

Consumers

From

To

Business*

Government

˘ Consumers

˘ Business

˘ Government

Transactions, $ million Total: $648,189 million

*Excludes large-dollar fund-clearing flows

≥

≥

≥

≥

≥

≥

both developed countries such as Germany and manyemerging markets, which have been growing at levelsranging from 21 to 95 percent. Many of these countries havepenetration rates that are less than a tenth of the US level.Our projections suggest that international spending willrepresent 61 percent of total bank card spending by the year2005, up from 54 percent in 1995 (Exhibit 3).

Technological innovationThe convergence of powerful technologies will eventuallydrive a wave of innovation that dramatically increases theoverall value proposition of credit cards. These technologiesinclude cards with microchips and stored-value magneticstrips, multi-application operating systems, scaleableprocessing, 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 identifyconsumers, for example, cards can verify, authorize, andauthenticate transactions using a range of access devices,including point-of-sale terminals, automatic teller machines,wireless phones, personal computers, set-top boxes, andpersonal digital assistants. The services they access couldinclude not only the full range of financial services but alsoe-commerce, health care, and government, education, andinformation services.

Meanwhile, payment networks will become much richersources of information, allowing issuers to analyze theircustomer transaction data far more minutely than theycurrently do to deliver true segment-of-one oƒfers. Rewardsand discounts will be tailored to the way consumers actuallyshop and use their cards. Issuers that have multiple cardrelationships with customers and their immediate familieswill use information technology to create linked suites ofcard products. These oƒferings will give customers muchgreater control over their accounts (for instance, theopportunity to have multiple subaccounts for variouspurposes), richer information (such as billing details in any format they desire), convenience, and value (includingreward programs linking multiple cards and accounts).



Exhibit 3

The international opportunity

Credit card volume in 1995

Growth in US market

Growth in foreign market

Estimated credit card volume in 2005

Total bank card spending, $ million

5,585

2,713

1,626

1,246

United States Rest of world

46% 54%

39% 61%

Banking on the futurePowered by superior skills in such areas as micro-marketing, risk management, servicing, and collection,focused specialists including MBNA, First USA, CapitalOne, and Providian continue to gain market share. Yetbanks that can improve their skills still enjoy opportunitiesof their own, since many of them maintain broad consumerfranchises with a variety of products. Banks can, forexample, move away from separate P&Ls to manage thelifetime value of consumers holistically across credit cards,debit cards, checking and savings accounts, automatic tellermachines, lines of credit, and investment accounts. Thiswould permit them to oƒfer consumers compelling bundlesthat 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. Thisposition of strategic strength means those that developcoherent payment strategies will enjoy a substantialcompetitive advantage. Paradoxically for the credit cardindustry, those banks that start viewing cards as just onepayment mechanism within an overall value proposition will probably emerge as the winners.



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