DARK CLOUDS ON THE HORIZON: A CALL FOR INNOVATION TO ... · per year from 91 bps in Q2 2014 to 131 bps in Q2 2018, while spend grew at five percent per year over this time frame

DARK CLOUDS ON THE HORIZON: A CALL FOR INNOVATION TO CREDIT CARD ISSUERS

EXECUTIVE SUMMARY

The US credit card industry has been basking in the glow of record profits for the last several

years while effectively fending off attacks from FinTechs and other disruptors. However, most

of this growth has been driven by macroeconomic conditions including a benign credit

environment, while fierce competition among issuers has eroded both net interchange

and net interest margin. If these trends continue and credit losses return to their long-term

average, we estimate that profits could decline by more than 60 percent.

Can an issuer buck this trend by getting off the promotional and rewards treadmill? We think

it’s challenging to do so given the implications for new customer acquisition and retention.

The answer instead lies in lessons from Big Tech and how they continue to reinvent products

as old as a taxi cab ride. Card issuers need to innovate to focus on solving big problems that

their customers have, build active solutions and generate flywheel momentum to sustain

growth. We suggest that they use the Oliver Wyman Financial Needs Hexagon to identify the

big problems and use a structured approach to identify and develop the active solutions.

A disciplined incubation process can help them generate flywheel momentum to sustain

these gains with consumers.

Copyright © 2018 Oliver Wyman. All Rights Reserved. 1

INTRODUCTION

The US credit card industry has been basking in the glow of record profits for the last several

years while effectively fending off attacks from FinTechs and other disruptors. We estimate

pre-tax margins of ~30 percent and return on assets approaching four percent, both of which

are remarkably impressive metrics in the context of US consumer banking.

The macroeconomic environment has been a big driver of card profits. Consumer spending

has been growing at 2-3 percent per year combined with GDP and population growth to deliver

purchase volume growth of eight percent per year and growth in outstandings of two percent

(See Exhibit 1). Unemployment has continued to decline resulting in charge-offs dropping

to below three percent before bouncing back, but still well below their long-term average

of five percent (See Exhibit 2). One could argue that the industry has “grown by breathing”.

Card issuers however, have been anything but complacent. Competition has been fierce

within the headline-grabbing rewards card category, where issuers are engaged in a game

of one-upmanship to deliver the richest possible rewards program to their target customers.

It is no surprise that total spend on rewards has grown at 14 percent per year, easily outpacing

growth in purchase volumes. Issuers are also competing intensely for revolving balances

using APR. The average APR on credit card balances has stayed flat over the last seven years,

despite the prime lending rate having increased by 200 bps (See Exhibit 3). This implies

a narrowing of the net interest margin caused by more competitive prime-plus rates and

more frequent and longer low-rate teasers.

These two side effects of fierce competition have impacted direct costs associated with

purchase volume and top line revenue associated with revolving balances but have largely

been covered up by the record low charge off numbers.


Exhibit 1: Growth in spend and outstandings

CREDIT CARD PURCHASE VOLUMES,$TN BY YEAR

REVOLVING CREDIT OUTSTANDINGS,$TN BY YEAR

201120102009 201420132012 2017 20162015 201120102009 201420132012 2017 20162015

0.70.70.8 0.80.70.7 0.90.90.8

2.11.91.82.62.42.2

3.4 3.12.8

+2%+8%

Source: The Nilson Report

Exhibit 2: Decline in charge-offs, average annual NCO rate for Credit Cards by year, In percent

200220012000 200520042003 2008 2009 20072006 20112010 201420132012 2017 20162015

9.4

2.9

Historical average: 5.0

3.6

Source: Board of Governors of the Federal Reserve System, seasonlly adjusted charge-off rates on consumer credit cards for all banks

Exhibit 3: Trends in net interest margin and rewards expense

2010 2016

$10 billion

$23 billion

+14 CAGR

2010

3

14

5

14

2018201620142012

CREDIT CARD APR AND PRIME RATE, IN PERCENT1 REWARDS COST, TOP SIX CREDIT CARD ISSUERS

Avg. APRPrime rate

1. Board of Governors of the Federal Reserve System G.19 Consumer Credit report, Economist Intelligence Unit.


DARK CLOUDS OVER THE HORIZON

These trends are not sustainable and if continue unchecked, will result in a significant erosion

of profit margins. ROA could decline to one percent if rewards costs and NIM compression

continue at this pace and charge-offs revert to their long-term average of five percent (See

Exhibit 4). This is not an outcome that any issuer or investor will be pleased with, but looks

reasonably likely.

Can an issuer buck this trend by getting off the promotional and rewards treadmill? We think

it’s challenging to do so given the implications for new customer acquisition and retention.

An indicative case study is Discover, which has had to significantly increase its rewards expense

in order to keep pace with its competitors. Discover’s rewards expense grew at 15 percent

per year from 91 bps in Q2 2014 to 131 bps in Q2 2018, while spend grew at five percent

per year over this time frame.

Exhibit 4: Future profitability scenarios

NCOs2 REWARDS COST3 NIM4 FUTURE PRE-TAX ROA

~1.9%

~1.1%

~2.5%

Scenario 2

Scenario 3

Scenario 1

Historical Average

Historical Average

Historical Average

Continued Growth

Continued Growth Continued Erosion

-

--

Source: analysis on profitability three years out

LESSONS FROM BIG TECH

As detailed in our 2018 State of Financial Services report5, we see three common ingredients

in the success of tech juggernauts such as Netflix and Amazon. First, they focus on solving

a big customer problem and establishing a beachhead solution to that problem. In the case

of Amazon, their beachhead was books; of course, they’ve expanded far beyond that

beginning, most recently to groceries with the $14 billion acquisition of Whole Foods.

2. Historical average = 500 bps.3. Assumes net cost (after factoring in increased transaction volumes) of +5% y/o/y for three years in rewards cost.4. Assumes continued erosion at same rate as from 2010 – 2018.5. The Customer Value Gap: Re-calculating Route, available at https://www.oliverwyman.com/our-expertise/insights/2018/jan/the-customer-value-gap-re-calculating-route.html

"So how should issuers respond? We believe the answer lies in lessons from Big Tech."


Netflix started out renting physical DVDs to address the challenges associated with renting

from physical stores. These and other tech leaders all started with a beachhead solution

for a clear customer problem, with a missionary zeal.

Next, Tech leaders create active solutions, ones that both bring about and engineer

the right experience and function as an integrated whole that evolves in lockstep with

changing customer needs. From the customer perspective, these solutions activate answers

to their problems, sometimes preemptively. And since these are their problems, the solution

sources components from an ecosystem of partners biased in favor of the customer, not

the provider’s economics. Following our example, Netflix started harvesting insights from

the viewing habits of its customers to create original content, thereby creating more content

they would like on the platform.

Third, they generate flywheel momentum to sustain growth. They relentlessly improve their

solutions with data and algorithms. The more they improve the experience, the more traffic

they drive to their solutions, the more underlying products get activated, which enriches

the data they collect and the accuracy and relevance of their algorithms, which ensures

a good customer experience, repeat visits, and greater share of wallet. Crucially, this customer

momentum generates market momentum, and the two taken together create – most

importantly, perhaps – disproportionate appeal to attract top STEAM (science, technology,

engineering, art, and math) talent. A rapidly growing and diverse workforce further fortifies

a growth ethos and culture of resilience that perpetuates growth. And so the flywheel spins

faster and faster. See Exhibit 5 for a summary illustration.

Exhibit 5: Three lessons from Big Tech

BIG PROBLEMS

ACTIVE SOLUTIONS

FLYWHEEL MOMENTUM

1

2

3

Books are...

• Expensive and heavy• Not always in stock at the local bookstore• But... non perishable and easy to store

Books CDs,DVDs

Electronics Jewelry Shoes GroceriesMarket-place

Web In-storeMobile Voice/AlexaKindle

Toys

Source: Oliver Wyman analysis


BIG PROBLEMS IN FINANCIAL SERVICES

Traditional financial services have focused on three categories of financial needs: “Borrow”,

“Safeguard” and “Grow”. But there are actually six categories. The other three are “Earn”,

“Spend” and “Transfer” (See Exhibit 6). In our research with consumers, they indicate that four

of the top five needs of their financial life relate not to legacy financial services businesses,

but instead to these other categories. So can credit card issuers solve these big problems?

Exhibit 6: The Oliver Wyman Financial Needs Hexagon

GROW

Need to grow my savingsmost optimally

Non-Traditional FS needsTraditional FS needs

TRANSFER

Need to easily transferfunds anytime, anywhere

SPEND

Need to spendmore wisely

EARN

Need to optimizemy earnings

BORROW

Need to obtain fundsat the right time and price

SAFEGUARD

Need to protectagainst undesired events

Source: Oliver Wyman analysis


BUILDING ACTIVE SOLUTIONS

We believe that by reorienting themselves around solving core financial needs, card issuers

can drive innovation that breaks the “interchange funded rewards” mindset and the “zero

teaser” treadmill. We offer some thought starters on what some of these active solutions

could look like, and encourage issuers to pursue a disciplined approach to unlocking even

greater sources of value that build flywheel momentum.

• GROW: Savings is not a traditional need addressed by cards, but as banks look to closely

integrate the core deposits and cards relationship, this could generate some interesting

ways to do so. A simple tactic that many issuers have tried is to offer bonus rewards

if they’re deposited into a linked checking or savings account. The flip side could also

work well – offer additional card rewards for meeting savings or investment goals e.g.

retirement account contributions. Research has shown that many rewards currencies enjoy

high perceived value which issuers can leverage to enhance the card value proposition

and build deeper customer relationships.

• BORROW: This is clearly a core need currently addressed by the product and there

has been a decent amount of innovation, particularly around enabling a customer

to convert a large purchase into an installment loan. Issuers might be concerned that

this will convert revolve balances to a lower APR installment loan. The flip side is that

this will likely drive some transactors to ‘revolve’ a purchase. 40 percent of the users

of American Express’s Plan It feature are transactors, indicating that the category can be

expanded6. The net economics will obviously be different for different issuer portfolios,

but issuers can manage leakage by targeting suitable transactors and potentially revolvers.

Startups like Affirm have shown that there is a considerable unmet customer need here,

which card issuers are in prime position to address.

• SAFEGUARD: Card issuers already offer various types of insurance, including purchase

protection and car rental insurance. However, usage of these features is abysmally low,

e.g. less than 0.1 percent of cardholders have used purchase protection. Could issuers

automate this, e.g. by searching for a lower price within the window and then helping

the cardmember claim the difference? Startups like Earny are doing exactly this and

generating significant user engagement. In addition, could issuers offer protection

benefits tied to specific purchases, e.g. extended warranty for a big-ticket electronics

purchase? This generates value to a customer right when their perception of the value is

very high, with limited impact on cost.

6. Source: American Express 2018 Investor Day materials


• EARN: Financial services firms have generally struggled to address this need, and arguably

it isn’t in their sweet spot. However, there are several ideas to be explored here. For

example, could cobrand cards provide additional benefits to employees, e.g. discounts on

gas for Uber drivers? Could payroll cards also double as store cards, or at least provide

similar benefits? Card issuers go to great lengths to cure delinquent borrowers, e.g.

by offering them payment plans, restructuring their debt and so on. Could they also

make it easier for them to get gig economy jobs to increase their income which will

significantly increase their odds of paying off that debt?

• SPEND: This is also another core need currently addressed by the product and one

which has seen a lot of innovation in terms of relevant and useful offers delivered to

card members. However, no one has cracked the nut on truly contextual offers and

adding sustainable value for merchants who fund the offers. In addition, card issuers can

take the next step of tying spend to budgets and just spend wiser overall, and not stop

at delivering the temporary euphoria associated with a discount.

• TRANSFER: This is arguably a need that disruptors like Venmo have addressed by allowing

money transfers using credit cards (albeit for a fee). If consumers are comfortable paying

these fees to Venmo, won’t they feel equally comfortable paying fees for domestic

and even cross-border money transfers? Card issuers could treat these as cash advances

to leverage an existing pricing construct but there are better segment-specific propositions

that can be built to truly create a valuable service.

GENERATING FLYWHEEL MOMENTUM

One or more of the active solutions above will create better value propositions and drive

new customers. The challenge lies in avoiding conventional management logic which favors

the scale game: If it’s not big enough to move the needle, why bother? This logic no longer works

because it ignores the fact that with active solutions, small steps lead to big impact, with

staged investments linked to ever-increasing velocity and flexibility. Getting on the flywheel

requires picking the right place to start, and investing in a systematic as opposed to near-

term economic benefit7.

We believe that it is imperative for card issuers to break the logjam of ever-more expensive

rewards and promo rates which drive temporary share gains while expanding the class of deal-

sensitive consumers. They can do that by addressing the big financial needs their customers

have and building active solutions. These will create better value propositions and drive new

customer growth, thus generating more data and insights which will fuel richer solutions.

The growth flywheel beckons.

7. For more details on how to operationalize these changes in a large organization, please refer to The Customer Value Gap: Re-calculating Route, The State of the Financial Services Industry 2018


Copyright © 2018 Oliver Wyman. All Rights Reserved.

Oliver Wyman is a global leader in management consulting. With offices in 50+ cities across nearly 30 countries, Oliver Wyman combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. The firm has more than 4,700 professionals around the world who help clients optimize their business, improve their operations and risk profile, and accelerate their organizational performance to seize the most attractive opportunities. Oliver Wyman is a wholly owned subsidiary of Marsh & McLennan Companies[NYSE: MMC].

For more information, visit www.oliverwyman.com

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DARK CLOUDS ON THE HORIZON: A CALL FOR INNOVATION TO ... · per year from 91 bps in Q2 2014 to 131 bps in Q2 2018, while spend grew at five percent per year over this time frame