By The Auriemma Consulting Group

Anyone who has ever constructed a financial model knows it typically includes three different forecasted scenarios: best case, worst case and expected case. It’s safe to say that what we experienced in 2008, and what we expect in 2009, is the worst case.

Card issuers and consumer lenders are challenged like they haven’t been in a generation. In 2008 and early 2009, delinquency and charge-off rates rose sharply, largely the result of the collapse of the U.S. housing market. Consumer spending is falling and is expected to get even worse. And banks have not been able to tap the securitization market, a main source of funding for card and consumer lenders, as buyers have left the market. As if the credit crisis doesn’t provide enough of a challenge, lenders will also have to deal with increasing legal and regulatory burdens.

When will the improvement begin? We simply don’t know. The recovery in the housing market will no doubt lead the way, but that market has yet to hit bottom. Perhaps now, with long-term mortgage rates starting to fall, people will begin buying again, lifting or at least putting a floor under home prices. But the unsecured consumer lending business, which trailed the housing market down, may not recover until well after home prices start to improve. Indeed, we haven’t yet seen quite as much contraction in the credit card market as we have in residential mortgages and auto lending. We are perhaps only at the end of the beginning of what will likely be a long and painful period for the U.S. consumer finance business.

We are confident, though, that even in markets as bad as this, opportunities will present themselves, and smart companies and managers will create their own opportunities. The credit card business is nothing if not resilient. The industry has been through tough times before, and lenders have always been able to adapt. These are tougher times than any of us have ever experienced. We are using ingenuity and flexibility to help clients manage through the crisis.

The UK Perspective

Just as in the United States, cards and payments organizations in the UK are challenged to do more with less and generate more revenue from existing customers. While the consumer credit crisis in the UK isn’t as severe as in the United States — at least not yet — payment processors, issuers and co-brand partners are watching developments closely in order to be prepared.

Lenders have become highly risk averse, and new investment is limited. Generating new originations has become very much a secondary consideration. However, we believe that opportunities to differentiate still exist. Perhaps now is the time to start planning and challenge existing and established paradigms.

Given the attention to retaining good customers, we believe issuers should be more heavily focused on customer service and stronger value propositions than ever before. Not only will this resonate with customers but also with the regulatory authorities, who have a powerful role to play in the shaping of the industry going forward. They should also consider more aggressive targeted rewards offers to increase spending, which retailers expect to be very poor for the near future.

One of the historic battlegrounds is share of wallet. The gauntlet has been thrown down to the industry to develop an innovative, game-breaking proposition. There are a number of different propositions beginning to emerge, but one consistent theme is that the consumer must be better rewarded for good behavior. We are also seeing a surge in interest to exploit the potential growth in prepaid cards. While the commercial model is still evolving, companies need to look at how prepaid cards can complement credit offerings. They also need to explore potential new segments, such as the underserved and overseas markets. Much of this drive is being led by the retailer community.

It’s also only a matter of time before retailers begin to look at decoupled debit. While the product has had some difficulty taking off in the United States, decoupled debit could be an exciting opportunity for UK retailers with strong brands looking for ancillary income streams. Despite the hype, contactless cards are not catching on with UK consumers as much as issuers and networks would like us to believe. According to the UK version of our Cardbeat publication, only 3 percent of UK consumers hold contactless cards. Rewards and APRs, as opposed to the convenience of technology, are still the prime motivating factors for consumers in choosing which card they use. Feedback from retailers also suggests that contactless technology is failing to meet expectations. McDonalds reports very low usage at its restaurants and has had problems with equipment. Boots, the UK pharmacy chain, said bank card transactions cost it significantly more each year than cash. Banks and payments networks may need to lower long-term merchant service fees to attract merchants.

Collections and Recoveries

Lenders and borrowers are suffering through one of the worst and tightest credit environments ever, certainly since the late 1980s and early 1990s. But as the unemployment rate only recently has begun to spike, it’s likely that the worst is yet to come. But the worsening delinquency and net charge-off numbers are only part of the story. Consumer behavior and attitudes toward debt repayment have changed dramatically. Lenders must be prepared to be able to respond.

Delinquency rates are up across all lines of consumer finance. Lenders see loans become uncollectible at much earlier stages, as well. Customers 60 to 90 days delinquent now have a much higher propensity to charge-off than in past years. More troubling, a large number of consumers are rolling straight through delinquency without making a payment. Similarly, lenders are seeing a rising volume of voluntary repossessions, with about a quarter of them from borrowers who were still current on their loans.

Personal bankruptcy rates are climbing despite the passage of a federal bankruptcy reform act, which was designed to make filing tougher for consumers. After an initial drop in filings following passage of the act, bankruptcies are rising sharply again.

In the first half of 2008, personal filings were up nearly 30 percent over the same period of 2007 and at about 75 percent of pre-reform act volumes. At the same time, more and more of these customers are defaulting on loans and moving to charge-off without filing for bankruptcy. We are now in a situation where collectors are contacting borrowers who are willing to pay but simply can’t.

In addition to changes in technology, some lenders have tried novel motivational tactics to try to establish customer contact, such as offering gift cards, phone cards or gas cards to get customers to call. Some lenders have gone as far as offering to match customer payments as a way to improve contact and repayment volumes.

Consumer Behavior

Perhaps now more than ever, understanding the drivers of consumer behavior will be critical to business success.

• In the United States, the percentage of consumers who carry a balance remained stable, but the average balance carried by revolvers increased 22 percent. At the same time, the payment rate continued to fall to a low of 17.4 percent in August, down more than three percentage points from 20.6 percent one year earlier. Consumers are borrowing more and paying back less. With the unemployment rate rising and forecasted to exceed 10.4 percent by November 2009, we can expect these trends to continue.

• About two-thirds of U.S. consumers carry a rewards card, a rate that has remained largely unchanged for the past two years. However, when we compared the results of a recent Cardbeat survey about the value of rewards programs with one from 2006, we found that most rewards cardholders think that their cards’ value propositions are less valuable than they thought they were two years ago. This was particularly the case with airline rewards cards, where consumers have reacted negatively toward the increase in mileage redemption fees, fewer available rewards seats, and the introduction of more fee-based services. Airline rewards cards have long been seen as “can’t miss” propositions. Now they, along with all other consumer propositions, must be revisited.

• Consumers currently see the ability to use their mobile phones to manage their credit card as an unnecessary benefit. But data collected in Cardbeat indicated that, among younger consumers, there is a strong appetite for time-saving technology, especially when it leverages mobile phones. This group in particular seems well-poised to adopt mobile services as their primary banking channel in the next five to seven years, with the mass market following soon thereafter.

Alliance Development

The co-branding environment has changed dramatically, too. As recently as last summer, many, perhaps most, people in the card business took co-branded programs for granted. Yes, everyone agreed that some deals were underperforming and that budgets would be tighter and under more scrutiny, but most were confident the majority of programs would survive in the end.

Since then, however, we believe there has been a transformation in thinking. The old way of doing business, where some portfolios performed well and others did not, is no longer going to be acceptable. Everything — from financial performance to marketing support dollars to the consumer value proposition — will be scrutinized. While co-branding remains an important strategy, some programs have not met their original expectations, either for merchant partners or their issuers. In the past, these programs might have been allowed to continue. Now, the law of the jungle — the survival of the fittest — will be the key determinant in whether many existing deals will continue to survive and which new deals will get done.

Tough negotiations lie ahead for both card issuers and their partners. Existing contracts will need to be revisited if they are going to be supported. Value proposition rewards to the consumer remain compelling in many programs, but need to evolve to better reflect current consumer attitudes. With so many people worried about their jobs and staying current on their mortgages, we would argue that more practical rewards and cash back may become more compelling, although airline miles and other higher end offers will continue to have a loyal constituency.

The number of bank mergers caused by the global financial meltdown — Wells/Wachovia, JPMorgan Chase/Washington Mutual, to name two — may create openings for other banks, should the original issuers make a strategic decision to limit the number or type of deals they have and let go of programs that don’t measure up. More likely, the shrinking number of large banks — and their own worries about survival — means the competition for issuers will be tougher than ever. In the future, banks will only tolerate successful (read: profitable) programs and will allow the underperforming deals to wither.

Outside the United States, co-branding remains an opportunity for issuers and their merchant partners, in both Europe and beyond. Although the UK market is well established, co-branding is less developed in continental Europe. The most notable new market is France, where Carte Bancaire’s long-standing restrictions against co-branding were finally dropped this year. Other areas of emerging growth for co-branding and loyalty coalitions include Central and Eastern European markets such as Poland, Romania, Hungary and Turkey, the latter of which is the third-largest credit card market in Europe after the UK and Spain.

Many of these markets have developed unique and innovative adaptations for local conditions. For example, in several Eastern European markets like the Czech Republic, cardholders who shop in the partner’s retail stores can stop at a cash desk in the store and receive an immediate cash rebate on purchases. Turkish banks in particular have taken advantage of chip technology to develop sophisticated loyalty programs. Another huge center of growth, of course, is China, where we have worked on assisting new entrants to the card market as well as on the development of popular co-brand and rewards programs.

This will be the most difficult and challenging period for co-branders and their issuer partners since our founding. At the same time, the co-brand credit card product is too valuable to fail, and will eventually thrive once this crisis period is over.

Debit and Prepaid Cards

This year has been another good year for debit cards, as share of spend compared to credit cards continues to rise. MasterCard and Visa both reported double-digit growth in spending and transactions processed.
And, the number of consumers receiving rewards on their debit cards continued to grow.

However, the debit arena is threatened by the federal UDAP regulations and the possible regulation of interchange. One of the requirements of UDAP allows consumers to opt out of overdraft fees caused by debit transactions. This could cause banks to respond by imposing more restrictive authorization rules, resulting in a greater number of declined transactions. These fee and interchange actions would have a particularly negative bearing on debit cards, which have a much thinner operating margin than credit cards and are thus more heavily dependent on fees and interchange revenue. Issuers must have sound strategies in the areas of expense control, rewards and revenue opportunities in place and ready for implementation should this happen.

In the UK, consumer research indicates there may be a large potential market for a decoupled debit card offering, unlike in the United States where the concept has failed to get off the ground. More than two-thirds of UK consumers questioned in a recent survey said they would be likely to apply for such a card. Many are drawn by the potential rewards incentives provided through the card. The concept of decoupled debit in the UK and continental Europe has the potential to repeat what happened in the co-branded credit card industry, opening the door for retailers to extend their reach into the wallets of UK consumers.

Currently, the fastest growing segment under the debit umbrella is the prepaid market. Prepaid cards are continuing to make inroads and are moving beyond simple plastic versions of gift certificates during the holidays.

While private label gift cards still dominate the prepaid market, network-branded cards are growing rapidly as more consumers realize they can use them at virtually any merchant that accepts credit and debit cards. Recently, we have helped non-bank entities to find bank alliance partners to issue their prepaid cards.

The real explosion is in the variety of new applications in both reloadable and non-reloadable cards. An increasing number of employees are diverting discretionary dollars to these accounts. Health spending accounts are growing in popularity as medical costs increase; many employers are partially funding the HSA deductibles onto prepaid cards. Notably, Comerica Bank hopes to generate millions of direct-deposit Social Security accounts with the money loaded onto prepaid cards. Some states pay unemployment and other benefits through prepaid cards. We believe that more creative uses for this versatile payment form will emerge. We also think that the issue of whether to offer BIN sponsorships needs to be considered as a potential area of growth for banks in the years to come, as more non-bank entities look to monetize their customer base and issuers look to add new products and improve cross-sell opportunities.

Alternate Payments

During the last year, growth and consolidation among the alternate payment providers means that they’re not so “alternate” anymore.

PayPal has continued to show impressive growth of more than 25 percent in the value of payments over last year. It also hit an important milestone, as its volume of transactions at other merchants exceeded those at parent company eBay. In particular, the company has had significant success with online retailers and airlines and recently signed up Wal-Mart for online purchases.

The company will become an even bigger force with its recent announcement that it is acquiring Bill Me Later, the other major player in alternate payments. The combination of PayPal and Bill Me Later under the ownership of eBay has fueled speculation about how much more share of online transactions they can grab and whether they have aspirations to expand into brick-and-mortar retail. We also note with interest a recent promotion that JPMorgan Chase sent to some of its cardholders, offering a $10 rebate for opening a PayPal account, funding it with a Chase card and making a purchase online. The promotion is noteworthy because PayPal is being positioned as complementary to credit cards rather than as a competitor.

We have previously observed that there are three major forces driving the development of alternative payment schemes: first, the desire of merchants to minimize the amount of interchange they pay; second, consumers’ concerns about security and privacy, especially for online purchases; and third, the desire to monetize new networks and technological infrastructure. It will be interesting to see how these forces play out in the changed economic landscape of 2009.

Consumers’ current pessimism and disenchantment with credit providers in general might also offer an opportunity for these new schemes to position themselves as a new and better alternative to the increasingly maligned credit card. Card issuers, therefore, need to be prepared to respond to even more competitive products on the payments turf.

Just as television has evolved well beyond the three major broadcast networks to encompass hundreds of cable networks, we expect to see a continued proliferation of specialized payment options beyond the traditional major networks. While not all of these new alternate payment providers will obtain enough critical mass to be successful, enough will survive to make the payments field resemble the current television landscape.

About the Authors 

This report was researched, written and compiled by the Auriemma Consulting Group, a provider of comprehensive management consulting to the financial services industry with a particular focus on payments, lending and retail banking. It was originally published in December 2008 as part of the firm’s annual update. To receive this report in the future, or for more information, contact info@acg.net.