The Profitability of Credit Card
Operations of Depository Institutions

Section 8 of the Fair Credit and Charge Card Disclosure Act of 1988 directs the Federal Reserve to transmit annually to the Congress a report about the profitability of credit card operations of depository institutions.1 This is the tenth annual report. The analysis here is based to a great extent on information from the Consolidated Reports of Condition and Income (Call Report) and two Federal Reserve surveys, the Quarterly Report of Credit Card Interest Rates and the Survey of Terms of Credit Card Plans.

Call Report Data
Every insured commercial bank files a Call Report each quarter with its federal supervisory agency. The Call Report provides a comprehensive balance sheet and income statement for each bank; however, it does not allocate all expenses or attribute all revenues to specific product lines, such as credit cards. Nevertheless, the data may be used to assess the profitability of credit card activities by analyzing the earnings of those banks established primarily to issue and service credit card accounts. These specialized banks are referred to here as "credit card banks."

For purposes of this report, credit card banks are defined by two criteria: (1) the bulk of their assets are loans to individuals (consumer lending), and (2) 90 percent or more of their consumer lending involves credit cards or related plans. Given this definition, it can reasonably be assumed that the profitability of these banks primarily reflects returns from their credit card operations.

The first credit card banks were chartered in the early 1980s, and the vast majority have been in operation only since the mid-1980s. To provide a more reliable picture of the year-to-year changes in the profitability of the credit card operations of card issuers, this report limits its focus to credit card banks having at least $200 million in assets. Most of these institutions have been in continuous operation for several years, particularly those with assets exceeding $1 billion, and are well beyond the initial phase of their operations.

As of December 31, 1998, thirty-one banks with assets exceeding $200 million met the definition of a credit card bank. At that time, these banks accounted for roughly 70 percent of outstanding credit card balances on the books of commercial banks or in pools underlying securities backed by credit cards. Although the dollar amount of all credit card debt held by large credit card banks increased nearly 9 percent from 1997, the share of all such debt held by these specialized banks declined roughly 10 percent from the previous year.2

In 1998, credit card banks with assets in excess of $200 million reported net earnings before taxes of 2.87 percent of outstanding balances adjusted for credit card-backed securitization.3 As table 1 (page 3) shows, returns on credit card operations for these large credit card banks increased 74 basis points or 35 percent from 1997. Returns on credit card operations in 1998, while higher than in the previous three years, were still well below their peak level of 4.06 percent attained in 1993. Although credit card profitability has fallen substantially since 1993 for the large credit card banks, credit card earnings still compare favorably to returns on all commercial bank activities.4 The average return on all assets, before taxes and extraordinary items, for commercial banks in 1998 was 1.81 percent.5

One problem that arises in assessing changes in profitability over time is that the sample of credit card banks may change somewhat from one year to the next. Thus, overall changes in profit rates from year to year reflect both real changes in activity and changes in the sample. To evaluate the effects of sample changes, the profitability of the specific banks included in the 1998 sample was examined over the period from 1986 to 1998 as well. Although the level of reported profitability for the constant panel of banks is somewhat different from that shown in table 1, the

intertemporal pattern of profitability remains essentially as shown in the table. For 1998, returns for the constant sample, like those of the full panel, increased 35 percent from 1997.

Changes from 1997 in overall returns to credit card operations can be better understood by reviewing how individual expense and revenue items changed.6 Although credit quality problems continued to put pressure on credit card earnings in 1998, much of the improvement in profitability owed to reduced provisions for future loan losses. Provisions for future losses as a percent of assets fell 16 percent from 1997 levels, the first substantial decline in several years. The fall in provisions for future losses suggests that banks' efforts to address credit quality problems are beginning to pay off. This interpretation is supported by the data pertaining to chargeoffs and delinquency rates: Chargeoff rates fell some from 1997 levels and the 30-day to 89-day delinquency rate for credit card plans at large credit card banks declined from 2.80 percent in 1997 to 2.69 percent in 1998. The 1998 rate was markedly better than the 3.27 percent delinquency rate experienced in 1996.

At the same time that provisions for future losses were falling for large credit card banks, overall expenses per dollar of assets increased marginally. Interest expenses fell about 8 percent from 1997, but this decline was offset by an increase in noninterest expenses. On the revenue side of the income statement, interest income as a percent of assets declined from the 1997 level, perhaps reflecting the availability of low introductory interest rates for new accounts and transferred balances. Offsetting much of the decline in interest income was a sharp increase in income derived from noninterest sources such as fees, merchant discounts, and credit card securitizations. Among the various types of fee income, penalty fees, for example, late payment fees, and cash advance fees increased substantially over 1997 levels.

General Discussion
Thousands of firms offer bank cards to consumers.7 Prior to the early 1990s, card issuers competed primarily by waiving annual fees and providing credit card program enhancements. Since then, however, interest-rate competition has played a much more prominent role. Many credit card issuers, including nearly all of the largest issuers, have lowered interest rates on many of their accounts below the 18 to 19 percent levels commonly maintained through most of the 1980s and early 1990s. Credit card interest rates in general have become more responsive to issuers' costs of funds in recent years as more issuers have tied their interest rates directly to one of several indexes that move with market rates (currently, about three-fifths of card issuers tie their interest rates on their largest credit card plans to a market index). Some issuers have segmented their cardholder bases according to risk characteristics, offering reduced rates to existing customers who have good payment records while maintaining relatively high rates for higher-risk, late-paying cardholders. Moreover, many issuers have attempted to gain or maintain market share by offering very low, temporary rates on balances rolled over from competing firms. Trends in credit card pricing are discussed in more detail below.

Over the past several years, competition has led to substantial shifts in market shares among the industry's largest firms. Most of the larger issuers have grown by acquiring credit card portfolios from smaller issuers or by merging with other firms. In addition, several of the more rapidly growing firms in recent years appear to have attracted market share by offering comparatively low-rate cards and attractive balance transfer programs. Others have gained market share through co-branding and associated rebate strategies, typically combined with waivers of annual fees.8

Aggressive competition for new customers during 1998 was at least partly the cause of a 6 percent increase from 1997 in the number of VISA and MasterCards in circulation, to a total of 429.2 million. The number of credit cards per cardholder also increased slightly, rising to an estimated 4.2 credit cards per person, up from 4.1 in 1997.9 The large number of direct mail solicitations, up significantly from 1997 levels, demonstrates the continuing desire of card issuers to expand and retain their base of cardholders.10 In 1998, as in 1997, credit card issuers were particularly focused on promoting "platinum" cards to either retain or expand their business. Solicitations for these more upscale cards that include a wide variety of enhancements and high credit limits accounted for 62 percent of all direct mail solicitations in 1998, up sharply from only 6 percent of all solicitations in 1996. While credit card holding continued to grow from 1997 to 1998, the rate of growth has moderated, consistent with the view that the market is becoming relatively saturated.

Recent Trends in Credit Card Pricing

Aside from questions about the profitability of credit card operations, considerable attention has been focused on credit card pricing and how it has changed in recent years. Analysis of the trends in credit card pricing in this report focuses on credit card interest rates because they are the most important component of the pricing of credit card services. Credit card pricing, however, involves other elements, including annual fees, fees for cash advances, rebates, minimum finance charges, over-the-limit fees, and late payment charges.11 In addition, the length of the "interest-free" grace period, if any, can have an important influence on the amount of interest consumers pay when they borrow on their credit cards.

Over the past several years, pricing practices in the credit card market have changed significantly. Many card issuers that in the past offered programs with a single interest rate now offer a broad range of card plans with differing rates depending on credit risk and consumer usage patterns. Moreover, as noted, many issuers have also moved to variable-rate pricing that ties movements in their interest rates to a specified index such as the prime rate.

At present, the Federal Reserve collects information on credit card pricing through two surveys of credit card issuers. Because of the significant changes in the pricing of credit card services, the Federal Reserve initiated the Quarterly Report of Credit Card Interest Rates (FR 2835a) at the end of 1994. This new survey collects from a sample of credit card issuers information on (1) the average nominal interest rate and (2) the average computed interest rate. The former is the simple average interest rate across all accounts; the latter is the average interest rate paid by those card users that incur finance charges. These two measures can differ because some cardholders are convenience users who pay off their balances during the interest-free grace period and therefore do not typically incur finance charges. Together, these two new interest rate series provide a better measure of credit card pricing. The Federal Reserve also collects detailed information on the pricing features of the largest credit card plan of a sample of issuers through the Survey of Terms of Credit Card Plans (FR 2572).12

Because information from the FR 2835a survey does not have an extended historical interest rate series for comparison purposes, this report on credit card profitability also presents data from the survey that preceded and was replaced by the FR 2835a, the Federal Reserve's Quarterly Report of Interest Rates on Selected Direct Consumer Installment Loans (FR 2835). Data from the FR 2835 indicate that credit card interest rates fell sharply from mid-1991 through early 1994 after being relatively stable for most of the previous twenty years (table 2, page 8).13 Since early 1994, credit card interest rates have fluctuated in a narrow range between 15.13 and 16.25 percent. For 1998, credit card interest rates averaged 15.63 percent. It should be emphasized that the interest rates reported after August 1994 are based on the new survey and are not directly comparable to the interest rates reported on the older survey.

The general decline in credit card interest rates from mid-1991 is the result of many factors, including greater competition based on this aspect of credit card pricing. The decline in rates also reflects, in large measure, the sharp drop in credit card issuers' costs of funds in the early part of this period. During the past two years, issuers' costs of funds have been relatively stable, as shorter term interest rates have fluctuated in a fairly narrow band.

Additional evidence on changes in credit card interest rates comes from the FR 2572. Although not precisely comparable from period to period because of some changes in the sample of reporters, this statistical series reveals a general decline in credit card interest rates in recent years. For example, only 11 percent of the respondents reported interest rates below 16 percent on their largest credit card plan as of September 1991, but 66 percent did so as of January 1999. In addition, the proportion of card issuers reporting that they utilize variable-rate pricing has also increased substantially since September 1991. As of September 1991, 23 percent of issuers used variable-rate pricing; as of January 1999 the proportion was 61 percent. The increased use of variable-rate pricing suggests credit card rates are likely to respond more quickly to changes in market interest rates in the future than they have in the past.

Percent
Year	Interest rate	Year		Interest rate
1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998	17.21 17.21 17.20 17.16 17.05 16.88 17.03 17.03 17.31 17.78 18.51 18.78 18.77 18.69 18.26 17.92 17.78 18.02 18.17 18.23 17.78 16.83 15.77 15.79 15.50 15.57 15.63	1993       1994       1995       1996       1997       1998	February May August November February May August November February May August November February May August November February May August November February May August November	17.26 17.15 16.59 16.30 16.06 16.15 16.25 15.77 15.29 16.23 15.94 15.71 15.41 15.41 15.64 15.52 15.13 15.72 15.79 15.62 15.33 15.62 15.85 15.72
*Prior to November 1994 interest rates were those reported in the Quarterly Report of Interest Rates on Selected Direct Installment Loans. Beginning in November 1994 interest rates are those reported on the Quarterly Report of Credit Card Interest Rates for those credit card holders incurring interest charges. Source: Board of Governors of the Federal Reserve System

NOTES

1 P.L. 100-583, 102 Stat. 2960 (1988).

2 The fall in market share of the credit card banks reflects a net decline in the number of such specialized institutions. During 1998, four credit card banks were involved in mergers or acquisitions with larger banking organizations. These larger organizations are not focused primarily on credit card activities and their earnings reflect a wide range of activities. For this reason, these organizations were not included in this analysis. In addition, five credit card banks that we included in the analysis of profitability for 1997 were dropped because they became more involved in other activities and no longer met the definition of a credit card bank. Partially offsetting these deletions from the panel, the 1998 sample includes four newly qualifying institutions.

3 Calculations are adjusted for securitizations because earnings as reported on the Call Report reflect revenues and expenses from outstandings both on the books of the institutions and in off-balance-sheet pools backing securities.

4 This report focuses on the profitability of large credit card banks, although many other banks engage in credit card lending without specializing in this activity. Reliable information on the profitability of the credit card activities of these other banks is not available, although their cost structures, pricing behavior, and consequently their profitability may differ from that of the large, specialized issuers. The relatively high returns of credit card banks are not surprising, since one would expect that monoline institutions, such as credit card banks, would need to earn higher returns to compensate for the greater risks of holding an undiversified portfolio.

In previous annual reports on credit card profitability, information from the Federal Reserve's Functional Cost Analysis (FCA) Program was used to measure the profitability of the credit card activities of smaller credit card issuers. These data tended to show credit card activities were less profitable for smaller issuers than for larger ones. As a consequence of modifications to the FCA program, the sample of banks reporting detailed information on credit card activity for 1997 and 1998 fell to a level too small to provide reliable estimates of credit card profitability for that year. For further discussion, see Glenn B. Canner and Charles A. Luckett, "Developments in the Pricing of Credit Card Services," Federal Reserve Bulletin, vol. 78, no. 9 (September 1992), pp. 652-666.

5 See Antulio N. Bomfim and William R. Nelson, "Profits and Balance Sheet Developments at U.S. Commercial Banks in 1998," Federal Reserve Bulletin, vol. 85, no. 6 (June 1999).

6 For an assessment of changes in credit card revenues and expenses, see James J. Daly, "A Balancing Act for Profits," Credit Card Management, May 1999, pp. 52-53.

7 Currently, roughly 6,800 depository institutions issue VISA and MasterCard credit cards and independently set the terms and conditions on their plans. Close to 10,000 other institutions act as agents for card-issuing institutions. In addition to the firms issuing cards through the VISA and MasterCard networks, two large nonbank firms, American Express and Dean Witter, issue independent general purpose credit cards to the public.

8 Under co-branding programs, the credit card bears the name of and is marketed to consumers of the co-branded product(s). Through use of the card, consumers typically accumulate "points" good for rebates on purchases of the co-branded product(s). One popular type of co-branding is with airline companies; in this case, "frequent-flier miles" are earned through credit card purchases.

9 Figures exclude debit cards. Source: The Nilson Report, April 1998.

10 An estimated 3.45 billion direct mail solicitations were sent by issuers during 1998, up significantly (about 15 percent) from about 3.0 billion in 1997 and 2.4 billion in 1996. The response rate on credit card solicitations in 1998 was estimated to be 1.2 percent, slightly lower than in 1997 but down sharply from an average of 2.5 percent over the period 1990 to 1993. Source: Leslie Beyer, "Return to Sender," Credit Card Management, April 1999, pp. 33-37.

11 In June 1996, the Supreme Court ruled that states may not regulate the fees charged by out-of-state credit card issuers. States have not been permitted to regulate the interest rates out-of-state banks charge. In making its decision, the Court supported the position previously adopted by the Comptroller of the Currency that a wide variety of bank charges, such as late fees, membership fees, and over-the-limit fees, are to be considered interest payments. This ruling will likely ensure that banks will continue to price credit cards in multidimensional ways rather than pricing exclusively through interest rates. Source: Valerie Block, "Supreme Court Upholds Nationwide Card Charges," American Banker, June 4, 1996.

12 The information in the FR 2572 survey is published twice a year by the Federal Reserve. Historically, the data were made available in a statistical release, the E.5 "Report of the Terms of Credit Card Plans." Beginning in 1995, the E.5 statistical release was discontinued and data are now included in a consumer brochure, entitled "Shop: The Card You Pick Can Save You Money."

13 For a comprehensive discussion of the factors that account for the levels and changes in credit card interest rates see, Glenn B. Canner and Charles A. Luckett, "Developments in the Pricing of Credit Card Services"; also U.S. General Accounting Office, U.S. Credit Card Industry (GAO/GGD-94-23, 1994).