How Your Rate Strategy May Limit Future Success
posted by Ben Rempe on Thursday, March 26, 2015
- card act
- fixed rate
- interest rate
Interest Rate Risk
Managing a community-based credit card portfolio has been rewarding for financial institutions the past few years.
With minimal effort, credit card accounts and balances have grown as financial institutions have taken advantage of market opportunities, as well as low charge-offs and cost of funds. The result has been a nice revenue stream, and ultimately your credit card portfolio has bolstered your loan to share ratio. However, consider for a moment, whether your portfolio is positioned for the future.
- How will your credit card portfolio perform when interest rates rise?
- Have you maximized the potential of your credit card portfolio, or have you just enjoyed the benefits of the status quo?
- Have you analyzed your portfolio to determine who is using your credit card?
- Have you examined your risk management profile to ensure the most credit-worthy cardmembers are being rewarded with the best rates and credit lines?
- Has your marketing strategy included a direct mail campaign that is segmented based on credit scores and other pre-screening criteria?
- Have you adjusted interest rates and credit lines?
If your credit card portfolio’s performance is benefitting your bottom line, then you may not see these issues as relevant. However, in the near future questions such as these will inevitably shape your conversation about how to maintain a successful portfolio.
A Result of CARD Act
There is an interest rate storm brewing. When CARD Act was first introduced in 2009, there were predictions about the negative effect this landmark legislation would have on credit card portfolios. Instead, after the initial changes, CARD Act has largely been a non-event for one reason: prime rates have remained at historic lows.
It is important to remember the impetus behind CARD Act was to protect the cardmember, which in the case of interest rates, was controlling how an issuer can make changes to the rate on current and future balances. Specifically, issuers cannot increase rates without a minimum 45-day notice, nor can interest rates on existing balances be changed. In addition, unless the card has a variable-rate pegged to an external index like Fed Funds or the Prime Rate, the rate cannot be adjusted. While financial institutions were able to once change rates overnight and the rates immediately applied to the existing balances, now changes can only be implemented on new balances, which means the “protected balance” or the balance at the lower rate can be carried on your books for years.
Achieving Target Yield
How do we know? TMG Financial Services (TMGFS) has been aggressive in managing the realities created by CARD Act. We have documented the length of time it takes for a portfolio to adjust to a new target yield under various scenarios. If you need to raise rates for any reason it will take between two and four years for a converted portfolio to reach the target yield. Because the balances are protected and often at a lower rate, we cannot make any adjustments to the balances we assume. We have to wait for those balances to roll from the books while we add new balances that are priced according to our risk models. Even with consistent marketing and other efforts to offset the lower-rate balances, it takes almost three years for the portfolio to rise to the target yield.
A higher yield in your credit card portfolio will take time, and you should contemplate that it will take three years to achieve target yield in today’s environment. How much longer will it take to achieve target yield when rates become volatile? This observed three-year timeframe has come at a time of unprecedented stability in rates. Because rates have remained at all-time lows, offering an interest rate below 10 percent on a fixed-rate portfolio hasn’t been a problem. All things considered, there have been few reasons to make adjustments to your portfolio.
We certainly understand the allure of a low rate. For years, many financial institutions have operated under the belief that a fixed-rate, low-rate credit card is consumer friendly and critical to attracting potential cardmembers. Unfortunately, we haven’t seen evidence this strategy is effective. It is true that savvy cardmembers look for the best offer, but their decision isn’t based on rate alone. A competitive card includes a combination of factors including: rewards, cardmember service, rate, fees and consistent marketing. Success will hinge on a sophisticated, balanced approach over a sustained period of time.
So at this point, we again ask: “How will your credit card portfolio perform when interest rates rise?”
Why Compression Will Come
While we are not in the business of predicting economic futures, we are students of what has happened historically. This much we know: the United States is currently in the least volatile period of Fed rates ever. This is not a surprise as the Federal Reserve has been deliberate in keeping the rates low to assist in the economic recovery. But look at where the rates are today. They are historically low and stable, and if you use past data as a guide, it is inevitable rates will increase. CARD Act provisions deliberately limit the options of credit card issuers. In the three years since CARD Act became law, the rates haven’t moved from historic lows, which means there hasn’t been a need to make interest rate adjustments to your portfolio.
If you are still not convinced, imagine the chairman of the Federal Reserve has announced rates will rise in the fourth quarter of 2015. If the rates increase 25 basis points, how does your portfolio perform? If the rates increase 100 basis points? How about 200 basis points? The conventional belief is rates will only go up a few basis points at a time, and most financial institutions can weather that – so long as the “few points” are not a frequent occurrence.
Let’s look at it another way using the two charts above. One is the average fixed-rate credit card portfolio, the other is a variable portfolio. The primary drivers are charge-offs and rates. In the fixed-rate portfolio, as soon as rates begin to rise, the margin immediately disappears because the portfolio was already priced into whatever cushion existed. In the variable-rate scenario, there is considerably more time to make adjustments because there are already triggers in place that allow the rate to adjust upward. Ultimately, the variable-rate portfolio is in a better position to make the necessary adjustments to remain a strong asset. The fixed-rate portfolio is left with few options because CARD Act rules remove many options.
Anticipating future interest rate environments is a critical factor in whether your credit card portfolio will remain a vital piece of your product offering. If you changed your portfolio from fixed to variable today, and if rates rise in 2015, we project only 50 percent of your balances would be re-priced to rise with interest rates.
Determining when rates will increase isn’t your only time consideration. Everything about running a successful portfolio takes time. As part of normal risk management you should conduct a periodic “rate shock” analysis of your portfolio. Additionally, you should evaluate the overall pricing and risk management strategies in relation to your credit card portfolio. Once you’ve determined the changes needed, they will take time to implement. Even if you are simply making adjustments in a variable-rate credit card portfolio, time is a factor because existing balances remain protected from the new interest rate and pricing structure – up to three years in our experience. For those moving from a fixed-rate to a variable-rate pricing structure, the road is more difficult and will become increasingly so once rates begin to rise.
And make no mistake, this conversation isn’t just for those financial institutions with a fixed-rate portfolio, it is also for those who do not have the resources to manage a successful credit card portfolio. To compete in the future, you must have a reasonable, long-term strategy for attracting new accounts or increasing balances. The competition is fierce. Six of the country’s largest issuers still hold approximately 90 percent of the market. Why? They offer low variable rates, and they are aggressively pursuing your best cardmembers with continuous marketing. They are singularly focused on increasing market share that incorporates sophisticated marketing and risk management strategies available to card issuers with the appropriate resources.
Changing from fixed-rate to variable-rate pricing won’t immediately address market share, but it will remove an obstacle to the future success of your program. Take the steps now to strengthen your credit card portfolio.
We are here to help and are committed to ensuring success in your financial institution with an effectively managed credit card program. If you’d like to receive a no-cost, risk free analysis of your credit card portfolio, contact us at 888.428.4720 x5288 or firstname.lastname@example.org.