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Report to the Congress on the Profitability of Credit Card Operations of Depository Institutions

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Submitted to the Congress pursuant to section 8 of the Fair Credit and Charge Card Disclosure Act of 1988
June 2008

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Section 8 of the Fair Credit and Charge Card Disclosure Act of 1988 directs the Federal Reserve Board to transmit annually to the Congress a report about the profitability of credit card operations of depository institutions.¹ This is the eighteenth 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 or mono-lined 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; few were in operation prior to 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, 2007, 17 banks with assets exceeding $200 million met the definition of a credit card bank. At that time, these banks accounted for approximately 69.2 percent of outstanding credit card balances on the books of commercial banks or in pools underlying securities backed by credit card balances.

In 2007, credit card banks with assets in excess of $200 million reported net earnings before taxes of 2.75 percent of outstanding balances adjusted for credit card-backed securitization.² As Table 1 shows, returns for large credit card banks fell 59 basis points or nearly 18 percent from 2006. The 2007 rate of return is the lowest since 1997 when the rate of return was 2.13 percent, although the rate of return in 2005 was not substantially above the 2007 rate.

Although profitability for the large credit card banks has risen and fallen over the years, credit card earnings have been consistently higher than returns on all commercial bank activities.³ For example, for all commercial banks, the average return on all assets, before taxes and extraordinary items, was 1.44 percent in 2007, down about 55 basis points or 28 percent from the 2006 level.⁴

One difficulty that arises in assessing changes in profitability over time is that the sample of credit card banks changes somewhat from one year to the next primarily because of mergers and acquisitions. 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 sample each year was also examined for the prior year. 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 virtually the same as shown in the table. For 2007, returns for the constant sample fell 58 basis points from the 2006 level, compared to a decline of 59 basis points for the credit card banks included in Table 1.

Changes from 2006 in overall returns to credit card operations can be better understood by reviewing how individual expense and revenue items changed among the credit card banks in the 2007 panel.⁵ Both interest income and interest expense rose over 2006 levels with net interest income increasing about 19 basis points or 4 percent. Both noninterest income and noninterest expenses fell over 2006 levels; on net, noninterest income declined about 17 basis points or 11 percent from 2006 levels. Much of the fall in average returns for credit card banks resulted from increased provisions for loan losses and chargeoffs. Net chargeoffs increased 24 percent over the 2006 level.

NOTE: Credit card banks are commercial banks with average managed assets (loans to individuals including securitizations) greater than or equal to 200 million dollars with minimum 50 percent of assets in consumer lending and 90 percent of consumer lending in the form of revolving credit. Profitability of credit card banks is measured as net pre-tax income as a percentage of average quarterly outstanding balances.

SOURCE: Reports of Condition and Income, 1986-2007
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General Discussion

Thousands of firms offer bank cards to consumers and consumers use their cards extensively.⁶ The Federal Reserve's G. 19 Consumer Credit report indicates that consumers carried a total of about $951.7 billion in outstanding balances on all their revolving accounts as of the end of 2007. 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 the interest rates on their plans directly to one of several indexes that move with market rates.

Today issuers segment their cardholder bases according to risk characteristics, offering reduced rates to existing customers who have good payment records while imposing relatively high rates on higher-risk or late-paying cardholders. Card issuers also closely monitor payment and charge volumes and adjust credit limits accordingly both to allow increased borrowing capacity as warranted and to limit credit risk. Many issuers have attempted to gain or maintain market share by offering very low, temporary rates on balances rolled over from competing firms and by offering a wide variety of enhancements. 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 rebates combined with waivers of annual fees.⁷

The U.S. general purpose credit card market is dominated by VISA and MasterCard labeled cards that combined accounted for an estimated 599.4 million cards in 2007, up 6.8 percent from 2006.⁸ In addition, American Express and Discover provided another 109 million general purpose cards to consumers in 2007.

Direct mail solicitations continue to be the primary channel used for new account acquisition and account retention. After reaching an all-time high in 2005 of 6.05 billion direct mail solicitations, direct mailings fell off in 2006 to 5.8 billion and fell another 10 percent to 5.2 billion in 2007.⁹ Response rates remained at 2006 levels in 2007 at 0.5 percent. Much of the falloff in solicitations during 2007 took place toward the later portion of the year as solicitations of higher credit risk prospects were curtailed in the face of rising credit card delinquencies and difficulties in the mortgage market which seeped over into credit card activities.

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.¹⁰ 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 use credit cards to generate revolving credit.

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 survey collects information from a sample of credit card issuers 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 interest rate series provide a measure of credit card pricing. The data are made available to the public each quarter in the Federal Reserve Statistical Release G.19 Consumer Credit. 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).¹¹

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, and fell again over the 1998-2003 period (table 2).¹² Since early 1998, credit card interest rates have fluctuated between 12.78 and 15.85 percent. For 2007, credit card interest rates averaged 14.68 percent, the tenth consecutive year such rates have averaged below 15 percent. (It should be emphasized that the interest rates reported after August 1994 are based on the new survey and are not strictly 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 on this aspect of credit card pricing. It is important to note that while average rates paid by consumers have moved in a relatively narrow band over the past several years, interest rates charged vary considerably across credit card plans reflecting the various features of the plans and the risk profile of the card holders served.

Additional evidence on changes in credit card interest rates comes from the FR 2572. Although not precisely comparable from period-to-period because of 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 79 percent did so as of January 2008 (the most recent report available). 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 2008, the proportion was 59 percent. The widespread use of variable-rate pricing suggests credit card rates are likely to respond relatively quickly to changes in market interest rates.

Note: 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.
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1. P.L. 100-583, 102 Stat. 2960 (1988). The 2000 report covering 1999 data was not prepared as a consequence of the Federal Reports Elimination and Sunset Act. The report was subsequently reinstated by law.
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2. Calculations are adjusted for credit card backed 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.
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3. 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. The cost structures, pricing behavior, and consequently the profitability of these diversified institutions 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 or those focused heavily on only one activity, such as credit card banks, would need to earn higher returns to compensate for the greater risks of holding an undiversified (by credit line) portfolio.

In earlier 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. The FCA program was discontinued in the year 2000. 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.
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4. Refer to William Bassett and Thomas King (2008), "Profits and Balance Sheet Developments at U.S. Commercial Banks in 2007," Federal Reserve Bulletin, vol. 94, p. A1-A39.
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5. For another assessment of changes in credit card revenues and expenses, see Jeffrey Green, (May 2008) "C&P's 2008 Bank Card Profitability Study and Annual Report," Cards and Payments, vol. 21, no. 5, pp. 36-38.
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6. Currently, over 6,000 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 Co. and Discover Financial Services, issue independent general purpose credit cards to the public.
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7. 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.
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8. Source: The Nilson Report, May 2008, Issue 902.
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9. Source: Synovate Mail Monitor, February 2008.
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10. 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 for this purpose. 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.
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11. 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 available exclusively on the Board's web site.
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12. 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 Accountability Office, U.S. Credit Card Industry (GAO/GGD-94-23, 1994).
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