By Nick Clements for Forbes
Although Brexit has dominated the headlines from the UK, another milestone has quietly been reached this week. Barclaycard, the largest and first credit card issuer in the UK, turned 50 years old. In the 1960s, on both sides of the Atlantic, a revolution in how we make payments and borrow money was started.
Fast forward, and in 2016 our wallets are overflowing with cards. According to data compiled by MagnifyMoney (where I work), Americans have balances of more than $900 billion on their plastic cards.
In the last few years, the Silicon Valley has taken direct aim at the credit card industry. Marketplace lenders have built businesses that promise to use big data and alternative underwriting models to refinance balances at lower interest rates. A long line of digital payment companies has been trying to replace plastic cards with mobile payments. Yet the card industry continues to grow, with new accounts up 16.3% according to the American Banker’s Association.
And in a world of declining banking returns, cards remain a rare bright spot.Barclaycard generated a Return on Equity globally of 23.4%, compared to just 9.5% from the corporate and investment bank at Barclays. According to theFederal Reserve, “although profitability for the credit card banks has risen and fallen over the years, credit card earnings have been almost always higher than returns on all commercial bank activities.”
Credit cards continue to attract a record number of customers while generating superior returns. How is this possible? Some of the profitability is certainly driven from a favorable macroeconomic environment. Interest rates are at all-time lows, while credit quality has continued to improve since the Great Recession. But that is not the entire story.
Many of the promises being made by new FinTech startups have been reality at card issuers for years. The largest companies make aggressive use of data and advanced, real-time statistical modeling. Plastic cards do not require branches, and customer service has become increasingly digital and low cost. The biggest issuers do not rely upon deposits from retail customers. Instead, institutional investors buy asset-backed securities. Using advanced data modeling to acquire consumers digitally and match borrowers with institutional investors is not a new concept: credit card companies have been doing it for years.
1. “Big Data” Driving Decisions
The largest issuers are almost exclusively data-driven businesses. Most hire hundreds of statisticians and data analysts to help build models for almost every major decision. Do you want to apply for a card? A model will make the decision. Do you want an increase in your limit? A model will decide.
Some companies have been using neural network models to detect fraudulent transactions in real-time. Although much has been made of the increasing fraud risk, the absolute levels of fraud remain low. In 2014, for every $100 of purchases made, only $0.0565 was fraudulent. Chip cards will certainly help reduce fraudulent transactions at merchants. However, advanced models will remain one of the most important ways to stop fraud.
2. Digital Consumer Experience
Although issuers have been creating digital functionality for years, the user experience has not been the best. But that is changing. Capital One acquired Adaptive Path, a digital design and user experience consultancy to bring talent in-house. Chase has been aggressively hiring non-banking talent from the digital space. And you can see the results in their apps. User ratings have been increasing for the biggest banks as they invest in both functionality and form.
3. Connecting Investors with Borrowers
The hyper-growth of the industry really began in the 1990s, thanks to a number of Delaware startups that grew rapidly and were eventually acquired by big banks. Businesses like FirstUSA (now Chase), MBNA (now Bank of America) and Juniper (now Barclaycard) built lending platforms that were low on cost and high on analytics. Because they were not banks, they depended largely upon institutional investors for funding. These Delaware businesses are strikingly similar to the marketplace lenders of today.
But Are Credit Card Companies Vulnerable?
There are two areas of vulnerability:
- Returns: The real threat of marketplace lenders offering refinancing is not their innovative use of technology or data modeling. It is their willingness to accept lower returns. Challenger brands willing to accept lower returns by charging lower rates certainly have the opportunity to take market share and compress profitability. But even large banks can get in on that game. Goldman Sachs, which is quietly building a lending business, will be a challenger brand in the consumer market.
- Model “Blind Spots” Behavior is changing, particularly with millennials. Traditional credit scores have been built on the assumption that every college student has at least one card and a credit history. With the CARD Act and changing behaviors, more millennials do not have a card or credit history. The traditional lending models are largely ignoring the “HENRYS” (high-earning not yet rich). SoFi has built a billion dollar business around a market segment that has not been well served by traditional banks. And SoFi is using that foundation to expand into other market segments.
Despite these vulnerabilities, the credit card industry demonstrates the power of data modeling, digital acquisition and capital market access. Delaware might not be as exciting as the Silicon Valley, but it certainly know how to do FinTech.
First appeared at Forbes