Analytical Engine

If you thrive on uncertainty, now is a great time to be an analytics practitioner in the credit card industry. Consider the following scenarios.

Today - Mr. Smith opens a new credit card account with an attractive APR and minimal annual fee. After the first four billing cycles, Mr. Smith has already defaulted once on the minimum payment due, thus becoming a riskier proposition for the issuer. While banks in general generate fee and interest revenue on such accounts, the risk of default (60-90 DPD/write-offs) starts increasing. At minimum, issuing the card at that particular “teaser” APR seems like a wrong decision. Damage control begins with the card issuer increasing the APR, which slowly helps the issuer cover its losses.

February, 2010 – Ms. Jones follows Mr. Smith’s bad example and quickly becomes another high risk customer. However, since CARD Act regulations are now in place, the issuer cannot increase the APR in the first six months of issue and without 45-days notice. The probability of default and hence, the loss-given-default amount starts increasing in the wake of a few decisions gone bad, and because the bank now lacks the flexibility to re-price.

These scenarios highlight implications of the CARD Act and UDAP regulations, legislation that aims “…to establish fair and transparent practices relating to the extension of credit under an open end consumer credit plan, and for other purposes.”

Among other things, UDAP and CARD:

• Restrict all interest rate increases during the first year:
• Restrict interest rate increases on existing balances;
• Allocate payments in excess of the minimum payment first to the balance with the lowest APR:
• Treat a payment as late unless the issuer provides a consumer with a reasonable amount of time to make payment:
• Place limits on fees and penalty interest:
• Increase notice for rate increases on future purchases.

The CARD Act takes effect in February 2010, and has significant cost and strategic implications for credit card issuers, not just in terms of their acquisition strategy, or risk profile of their current/future base, but also a fundamental shift in their strategic outlook towards the credit card business.

We think the implications for the use of analytics within the card industry are profound.

• One of the first and foremost thoughts is: “Will the card industry shrink?” Issuers must carefully consider their exposure vis-à-vis the risks associated with it, given the new limits imposed on them. How should issuers evaluate their risk exposures differently, given the new regulatory constraints?

• Do we see “revenue-at-risk” models (a term more commonly used in telecom) becoming the latest analytics investment for credit card issuers, to better understand the pockets of revenue that are most at risk for issuers? How are the issuers going to deal with the challenges of revenue replacement? How will the issuers treat the transactors vis-à-vis revolvers?
• Will Lifetime Value (LTV) or profitability modeling supplement or supercede risk/price modeling as related to the overall underwriting function, both for acquisition and base management?
The big strategic question is this:How should issuers look at their portfolio and their products now to determine the customers they want, and the products and pricing they offer in order to retain profitability and position for competitive growth in the new era?

For analytics thinkers, here is an example where numerous forms of credit card analytics (pricing, underwriting, risk management, customer acquisition, customer management, and customer attrition, ) are suddenly in play, and all at the same time, together. Everyone wishes for a quick solution to this development, realizing fully well that there is none. The risk models and pricing strategies used by issuers have been built and stabilized over decades with great attention to detail. Even so, they require careful handling every few cycles as the underlying economic and social structure of the population changes. Given all this, is there a good near term fix that can be rolled out for testing?

The road ahead will be strewn with a series of analyses and tests that issuers will experiment with to assess the impact of the changing regulatory environment on the credit card industry.
In a subsequent post, we will talk about the different analytics that we think will be of immense value in these changing times. But for now, let us all think about the change and its impact.