View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

March 1, 1988

eCONOMIC
COMMeNTaRY
Federal Reserve Bank of Cleveland

----

The Bank Credit-Card
Boom: Some Explanations
and Consequences
by Paul R Watro

I

n financial activities, there is a tradeoff between risk and return. The
higher the risk, the greater the
required return.
This fundamental principle helps
explain why credit-card interest rates
are still in the 17-18percent range,
even though rates on most other
kinds of bank loans have fallen significantly since the early 1980s.
Credit-card loans have higher interest
rates because they generally lack collateral and involve more risk. If such
loans are not repaid, banks often must
charge them off and suffer a loss.
In the last three years, the rate of such
charge-offs has more than doubled,
indicating a decline in credit quality.
In spite of this, however, strong consumer demand and attractive profit
margins have led to greater creditcard lending by banks.
This increased lending comes at a time
when fewer potential customers are
without credit cards and when banks
are using market segmentation to combat the more intense competition,
which has made growth in credit· card
operations more expensive.

ISSN 0428·1276

In view of the expense, the risk, and
the higher rate of charge-offs, are
banks acting irrationally when they try
to increase their credit-card lending
business? The answer depends on the
trade-off between risk and return.
In this article, we discuss factors
behind the surge in credit-card lending, and identify factors related to
risk-taking that help explain why
some banks have higher charge-off
rates than others.
• Consumer Demand
Consumer spending has propelled
economic growth, particularly in the
early years of the current economic
expansion, which began in November
1982.1 Rising income levels and
improved wealth positions have contributed to increased consumer
spending. Consumers have also been
borrowing more. For instance, consumer installment debt as a percentage of disposable personal income
rose from 14 percent in 1982 to over
18 percent in the last year or two.
Credit cards have been the fastestgrowing form of consumer credit. In
the last five years, credit-card balances
have more than doubled and now
account for nearly 25 percent of all
consumer installment debt, compared

-

What is behind the surge in creditcard lending and the sharp rise in
credit-card charge-off rates at banks?
Factors related to risk-taking help
explain why some banks have higher
charge-off rates than others.

to 20 percent in 1982. This growth
has occurred even though lenders
charge higher rates on credit-card
loans than on other consumer loans,
such as auto loans. One reason for
the higher rates is that credit-card
credit has no collateraJ.2 If the cardholder defaults, the credit-card issuer
is without recourse against the merchandise purchased with the card.
The growing popularity of credit
cards may be attributed to many factors. From a user standpoint, acceptance, convenience, safety, and flexibility have encouraged consumers to
make greater use of charge cards.
Credit-card transactions provide users
with a convenient way to maintain
records for tax and other purposes
and a way to minimize the risk and
financial cost of carrying large cash

balances. Credit cards might even be
superior to checks or cash for some
transactions, such as those in foreign
countries and those over the telephone and through the mail.
• Banks' Role
Spurred by growing consumer
demand, high returns, and declining
commercial lending profits, many
banks have placed greater emphasis
on consumer lending, especially on
credit-card lending. As a percentage
of total bank loans, credit -card receivables jumped from 3 percent in 1982
to over 5 percent by year-end 1986.
Banks now hold close to two-thirds of
the credit-card outstanding balances,
up from just over one-half in 1982.
Technological advances, economies of
scale, deregulation, and favorable market conditions have encouraged lenders to mass-market credit on a nationwide basis. Banks issuing credit cards
face sizable volume requirements in
order to achieve profitability because
of high operating costs. This is why
many banks that offer credit cards
participate with larger banks or organizations that actually issue cards and
determine their rates, fees, and service features.' Because of economies
of scale in credit-card operations,
banks have an incentive to expand
and become the low-cost issuers.'
When the cost of money fell significantly in the mid-1980s, banks generally sought to expand credit-card
lending through mass-mailing solicitations with preapproved credit.
Banks have largely relied on creditcard availability and services rather
than on price in issuing cards.
Credit-card issuers generally have
increased credit limits, have provided
a wider range of enticements, and
have offered credit to riskier groups
of consumers who were previously
unable to obtain credit cards. The
spreads berween funding costs and

credit-card interest rates enable banks
to buffer the expected higher credit
losses associated with lending to riskier customers.
Credit-card accounts may be more
valuable than their direct dollar
return if they provide banks with useful marketing and credit information.
For instance, banks could judge the
credirworthiness of cardholders for
larger loans based on their payment
history. Some banks, such as Citibank,
have apparently used credit-card customers as target groups for selling
insurance products and for penetrating out-of-state markets. Moreover,
banks typically include advertisements in monthly bill statements in
an effort to sell other banking services to credit-card customers.
Perhaps earnings have been the
underlying force behind the rapid
expansion in credit-card operations at
banks. Chart 1 shows that credit-card
profit margins have improved sharply
and have been better than those from
other types of lending in recent years.'
From 1984 through 1986, the annual
pretax net returns on bank credit-card
balances averaged 3.6 percent. In the
same period, banks earned 2.4 percent on real estate mortgages, 2.7
percent on consumer installment
debt and 1.4 percent on commercial
and other loans. Bank credit-card
returns have benefited not only from
the robust consumer demand, but
also from the removal or relaxation of
state usury laws in the early 1980s
and from the large decline in funding
costs from those years.
Over a longer period, however,
credit-card profits look quite different. Credit-card issuers experienced a
severe profit squeeze in the 1979-81
period because of historically high
interest rates and binding usury laws.
Credit-card earnings were generally
more volatile and lower than earnings
from other loans. Greater volatility
may have reflected a combination of
factors, including changes in the cost
of funds, binding usury ceilings, and
the higher degree of default risk in
credit-card lending.

Credit-card performance was also quite
poor during the developing stages of
bank credit-card systems." In addition
to operating problems, banks underestimated the burden of controlling
credit losses. In an effort to grow and
to gain market acceptance, banks
turned to mass mailing of unsolicited
credit cards during the late 1960s.This
marketing strategy led to large-scale
credit and fraud losses, that, in turn,
led to legislation prohibiting the unsolicited distribution of credit cards.'
Despite a shaky track record, the
recent prosperity in credit-card earnings has spurred new entrants and
more intense competition in the
credit-card business. A few years ago
Sears introduced the Discover Card,
which has not become profitable yet."
American Express also introduced the
Optima card, which offers a revolving
credit line with a lower interest rate
than most bank cards."
With greater competition and fewer
consumers without credit cards, however, large-scale expansion is probably
becoming more expensive and more
risky. Nevertheless, mass solicitations
with preapproved credit lines, waived
annual fees, and other enticements
continue to be common among large
issuers.
In an effort to build consumer loyalty,
many banks have sought to tie credit
cards to affinity groups such as airlines, hotel chains and alma maters
during the past year or rwo. The
sponsoring organization typically
endorses the bank's card for financial
compensation based on members'
acceptance and use of the card, While
aggressive marketing and liberal
credit policies have promoted creditcard growth, some of the expansion
came at the expense of loan quality.

-

CHART 1 NET PRETAX PROFIT MARGINS ON
VARIOUS lYPES OF BANK CREDIT
Percent credit type outstanding

6~----------------------------------~

3
2
1

Commercial
and other

\I

-1

-2~--~----~--~----~--~----~--~--~
1971
1973

1975

1977

1979

1981

1983

1985

NOTE: Based on annual data from the Federal Reserve System's Functional Cost
Analysis.

CHART 2 NET CHARGE-OFFS ON BANK CREDIT CARDS
(AS A PERCENT OF CREDIT-CARD AVERAGE BALANCES)

4
3

3.2

-

2~

2.4

1.5

1~

o

1984

1985

NOTE: Based on data from reports of income and condition

1986
for all banks.

• Credit Quality
One widely used measure of loan
quality is net charge-offs.w These are
loans judged to be uncollectable in a
given year, minus any recoveries of
loans previously charged off. Banks
generally write off unsecured loans,
such as credit-card receivables, faster
than well-secured loans like home
mortgage loans.
Chart 2 shows that bank credit-card
quality has deteriorated. Net chargeoffs as a percentage of credit-card
balances have more than doubled,
jumping from 1.5 percent in 1984 to
3.2 percent in 1986.The deterioration
reflects many factors, some and perhaps the most important of which have
no relation to the business cycle.
In our study, we examine 148 large
banking organizations to identify the
level and variability of credit-card
charge-off rates among individual
banks. We look at banking organizations as a unit rather than as individual banks because some organizations have shifted credit-card balances
among subsidiary banks. In fact, more
than 20 bank holding companies
operate special banks dealing primarily in credit-card accounts."
Our sample included all bank holding companies established before
1982 that have a subsidiary bank with
assets over $1 billion and that have
total credit-card receivables of more
than $25 million. These banking
organizations hold 80 percent of bank
credit-card receivables and accounted
for nearly 85 percent of credit-card
charge-offs at banks in 1986.
Credit-card charge-off rates varied
considerably among our bank sample. Net charge-offs as a percentage of
credit-card balances ranged from -0.6
to 8.9 percent and averaged 2.2 percent for 1986.12 Charge-off differences could be due to numerous factors
including differences in luck, economic conditions, and risk-taking.

balances. Credit cards might even be
superior to checks or cash for some
transactions, such as those in foreign
countries and those over the telephone and through the mail.
• Banks' Role
Spurred by growing consumer
demand, high returns, and declining
commercial lending profits, many
banks have placed greater emphasis
on consumer lending, especially on
credit-card lending. As a percentage
of total bank loans, credit -card receivables jumped from 3 percent in 1982
to over 5 percent by year-end 1986.
Banks now hold close to two-thirds of
the credit-card outstanding balances,
up from just over one-half in 1982.
Technological advances, economies of
scale, deregulation, and favorable market conditions have encouraged lenders to mass-market credit on a nationwide basis. Banks issuing credit cards
face sizable volume requirements in
order to achieve profitability because
of high operating costs. This is why
many banks that offer credit cards
participate with larger banks or organizations that actually issue cards and
determine their rates, fees, and service features.' Because of economies
of scale in credit-card operations,
banks have an incentive to expand
and become the low-cost issuers.'
When the cost of money fell significantly in the mid-1980s, banks generally sought to expand credit-card
lending through mass-mailing solicitations with preapproved credit.
Banks have largely relied on creditcard availability and services rather
than on price in issuing cards.
Credit-card issuers generally have
increased credit limits, have provided
a wider range of enticements, and
have offered credit to riskier groups
of consumers who were previously
unable to obtain credit cards. The
spreads berween funding costs and

credit-card interest rates enable banks
to buffer the expected higher credit
losses associated with lending to riskier customers.
Credit-card accounts may be more
valuable than their direct dollar
return if they provide banks with useful marketing and credit information.
For instance, banks could judge the
credirworthiness of cardholders for
larger loans based on their payment
history. Some banks, such as Citibank,
have apparently used credit-card customers as target groups for selling
insurance products and for penetrating out-of-state markets. Moreover,
banks typically include advertisements in monthly bill statements in
an effort to sell other banking services to credit-card customers.
Perhaps earnings have been the
underlying force behind the rapid
expansion in credit-card operations at
banks. Chart 1 shows that credit-card
profit margins have improved sharply
and have been better than those from
other types of lending in recent years.'
From 1984 through 1986, the annual
pretax net returns on bank credit-card
balances averaged 3.6 percent. In the
same period, banks earned 2.4 percent on real estate mortgages, 2.7
percent on consumer installment
debt and 1.4 percent on commercial
and other loans. Bank credit-card
returns have benefited not only from
the robust consumer demand, but
also from the removal or relaxation of
state usury laws in the early 1980s
and from the large decline in funding
costs from those years.
Over a longer period, however,
credit-card profits look quite different. Credit-card issuers experienced a
severe profit squeeze in the 1979-81
period because of historically high
interest rates and binding usury laws.
Credit-card earnings were generally
more volatile and lower than earnings
from other loans. Greater volatility
may have reflected a combination of
factors, including changes in the cost
of funds, binding usury ceilings, and
the higher degree of default risk in
credit-card lending.

Credit-card performance was also quite
poor during the developing stages of
bank credit-card systems." In addition
to operating problems, banks underestimated the burden of controlling
credit losses. In an effort to grow and
to gain market acceptance, banks
turned to mass mailing of unsolicited
credit cards during the late 1960s.This
marketing strategy led to large-scale
credit and fraud losses, that, in turn,
led to legislation prohibiting the unsolicited distribution of credit cards.'
Despite a shaky track record, the
recent prosperity in credit-card earnings has spurred new entrants and
more intense competition in the
credit-card business. A few years ago
Sears introduced the Discover Card,
which has not become profitable yet."
American Express also introduced the
Optima card, which offers a revolving
credit line with a lower interest rate
than most bank cards."
With greater competition and fewer
consumers without credit cards, however, large-scale expansion is probably
becoming more expensive and more
risky. Nevertheless, mass solicitations
with preapproved credit lines, waived
annual fees, and other enticements
continue to be common among large
issuers.
In an effort to build consumer loyalty,
many banks have sought to tie credit
cards to affinity groups such as airlines, hotel chains and alma maters
during the past year or rwo. The
sponsoring organization typically
endorses the bank's card for financial
compensation based on members'
acceptance and use of the card, While
aggressive marketing and liberal
credit policies have promoted creditcard growth, some of the expansion
came at the expense of loan quality.

-

CHART 1 NET PRETAX PROFIT MARGINS ON
VARIOUS lYPES OF BANK CREDIT
Percent credit type outstanding

6~----------------------------------~

3
2
1

Commercial
and other

\I

-1

-2~--~----~--~----~--~----~--~--~
1971
1973

1975

1977

1979

1981

1983

1985

NOTE: Based on annual data from the Federal Reserve System's Functional Cost
Analysis.

CHART 2 NET CHARGE-OFFS ON BANK CREDIT CARDS
(AS A PERCENT OF CREDIT-CARD AVERAGE BALANCES)

4
3

3.2

-

2~

2.4

1.5

1~

o

1984

1985

NOTE: Based on data from reports of income and condition

1986
for all banks.

• Credit Quality
One widely used measure of loan
quality is net charge-offs.w These are
loans judged to be uncollectable in a
given year, minus any recoveries of
loans previously charged off. Banks
generally write off unsecured loans,
such as credit-card receivables, faster
than well-secured loans like home
mortgage loans.
Chart 2 shows that bank credit-card
quality has deteriorated. Net chargeoffs as a percentage of credit-card
balances have more than doubled,
jumping from 1.5 percent in 1984 to
3.2 percent in 1986.The deterioration
reflects many factors, some and perhaps the most important of which have
no relation to the business cycle.
In our study, we examine 148 large
banking organizations to identify the
level and variability of credit-card
charge-off rates among individual
banks. We look at banking organizations as a unit rather than as individual banks because some organizations have shifted credit-card balances
among subsidiary banks. In fact, more
than 20 bank holding companies
operate special banks dealing primarily in credit-card accounts."
Our sample included all bank holding companies established before
1982 that have a subsidiary bank with
assets over $1 billion and that have
total credit-card receivables of more
than $25 million. These banking
organizations hold 80 percent of bank
credit-card receivables and accounted
for nearly 85 percent of credit-card
charge-offs at banks in 1986.
Credit-card charge-off rates varied
considerably among our bank sample. Net charge-offs as a percentage of
credit-card balances ranged from -0.6
to 8.9 percent and averaged 2.2 percent for 1986.12 Charge-off differences could be due to numerous factors
including differences in luck, economic conditions, and risk-taking.

TABLE 1

BANK CHARGE-OFFDIFFERENCES
ON CREDIT CARDS
HighCharge-off
Group

LowCharge-off
Group

Difference

7.9%

3.7%

4.2%a

Change in credit-card balances/
total loans (1983 to 1985)

2.5

-1.0

3.5a

Loans/assets

63.9

60.8

3.1

Revenues from credit-cards/
average credit-card balances

19.3

14.9

4.4a

Credit-card balances (billions)

$1.8

$0.1

$1.7b

Assets (billions)

27.8

5.0

22.8b

Credit-card balances/
total loans

a. Denotes statistical significance at the 1 percent level.
b. Denotes statistical significance at the 5 percent level.
NOTE: Data are as of year-end 1986, unless otherwise noted.
SOURCE:Federal Financial Institutions Examination Council's Reports of Income and
Condition for banks.

We examine credit-card growth, specialization, volume, revenue, loan-toasset ratio and organizational size as
potential explanatoiy factors for
interbank charge-off differences. Each
of these factors is related to risktaking in one way or another.
Banks that experience faster creditcard growth might be expected to incur higher charge-offs because a tradeoff may exist between credit growth
and credit quality. Lenders that specialize in or devote more resources to
a certain type of lending may also be
more aggressive and extend riskier
lines of credit in those areas. Alternatively, those banks may be better at
managing risk. Specialization is measured by the current share of loans
held in credit-card receivables and
growth is measured by the change in
this ratio over the two previous years.

There is a positive relationship between risk and returns. Lenders charge
higher rates or require higher revenues for riskier loans. Accordingly, one
would expect to find higher credit-card
charge-offs at banks that generate
higher revenues per dollar of creditcard balances. We also examined
loan-to-asset ratios as a measure of an
organization's overall attitude towards
risk. Higher ratios are thought to
reflect greater risk-taking since loans
are usually riskier than other assets,
such as government securities.
Product and geographical diversification helps to reduce risk. The largest
credit-card issuers with a nationwide
customer base should have more
geographically diversified portfolios
that could lower charge-off rates. On
the other hand, the largest banking
organizations might choose to have
lower credit standards for issuing
credit cards because of potentially
lower risk levels from greater product
and loan diversification.

We use two common tests to ascertain whether or not credit-card
growth, specialization, volume,
revenue, loan-to-asset ratios, and
organizational size had any influence
on charge-off rates. First, we compare
the sample extremes-those with the
highest and lowest charge-off rates.
The high group included those with
charge-off rates greater than 4.0 percent and the low group included
those with charge-off rates less than
1.0 percent. For each variable, average
values were computed for both
groups and the difference was tested
for statistical Significance. Second, to
explain differences in charge-off rates
for the whole sample, we use a statistical technique that isolates the effects
of one variable while taking into
account other factors.
Our analysis, as expected, revealed
that the 18 banking organizations in
the high-charge-off group differed
Significantlyfrom 21 banking organizations in the low-charge-off group.
The table shows that the high-chargeoff banks were much larger, placed
greater emphasis on credit-card lending, and charged higher prices. The
high-charge-off organizations experienced much faster credit-card
growth and, on average, they held
$1.8 billion in credit-card receivables,
which accounted for nearly 8 percent
of their loans. Average credit-card
revenues generated by the highcharge-off group were 4.4 percent
higher than the low-charge-off group.
Although we do not know if higher
revenues were sufficient to offset
higher default costs, this finding suggests that banks are taking credit risk
into account at least to some degree
when pricing credit cards. Higher

-

CHART 3 CREDIT-CARD REVENUE BY CHARGE-OFF GROUPS
(AS A PERCENT OF CREDIT-CARD AVERAGE BAlANCES)
Revenue
2 0-

19.3

18-

17.4
16.9
16.2

1
6-

14.9

1
4-

~
0

Less than 1

1.0-1.9

2.0-2.9

3.0-3.9

4.0-8.9

Net charge-offs
NOTE: Based on 1986 data from reports of income and condition for bank sample.

charge-offs, therefore, do not necessarily imply inferior performance or
cause for immediate concern, as long
as lenders are being adequately compensated for credit risk.
The strong positive relationship
between revenues and charge-offs is
also depicted in chart 3. The chart
shows average credit-card revenues
for the whole bank sample broken
out into five groups according to the
level of credit-card charge-offs. Banks
in the higher charge-off groups progressively earned higher revenues,
suggesting that they charge higher
rates and fees but lend to riskier
customers.
However, the loan-quality/revenue
relationship could be spurious, that
is, other factors could be causing it.
When we isolated the influence of
individual factors while taking into
account other factors, such as asset
size and the percentage of loans in
credit-card balances, we still found
that banking organizations with higher
credit-card charge-offs had significantly higher credit-card revenues.

Other results were also similar to the
findings listed in the table." One
important exception was that creditcard balances were found to be negatively related to charge-off rates when
asset size was taken into account.
This finding, although statistically
Insignificant, is consistent with the
view that larger portfolios are generally more diversified and carry less
risk than smaller portfolios.
• Conclusion
Bank credit-card lending has
increased rapidly since the early
1980s.This increase has been fueled
by a range of factors, including robust
consumer demand, improved technology, removal or relaxation of state
usury laws, economies of scale, crossselling potential, substantial decline
in funding cost and attractive profit
margins. Higher credit-card earnings
have attracted new competitors, more
aggressive marketing and more liberal credit standards that, in turn, led
to a sharp rise in credit-card losses.

Credit-card charge-offsvaried considerably among issuers. Banks with higher
propensities to take risk incurred
higher charge-off rates. As long as
issuers receive adequate compensation for credit risk, however, chargeoffs are not necessarily a problem.
Also, the potential impact of high
credit-card charge-offs on the financial
condition of banks is reduced by the
fact that even the most aggressive
banks in credit-card lending still have
relatively small portions of their assets
and loans in credit-card receivables.

-

Paul R. Watro is an economist at the Federal
Reserve Bank of Cleveland.
The author
would like to thank john M Davis, Mark S.
Sniderrnan, andjamesB.
Tbomson for belpful comments. Research assistance was provided by john N. McElravey and Daniel].
Martin.
The views stated herein are those of the
author and not necessarily those of the Federal Reseroe Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

•

Footnotes

1. See K.]. Kowalewski, "Is the Consumer
Overextended?,"
Economic Commentary,
Federal Reserve Bank of Cleveland,
November 1986.
2. However, this does not necessarily
explain why credit-card rates have not
fallen in tandem with other loan rates.
3. There are approximately 3,000 banks
and other institutions that issue credit
cards. "Interest Rate Controls on Credit
Cards - An Economic Analysis," Lexicon,
Inc., October 1985.
4. See Christine Pavel and Paula Binkley,
"Costs and Competition in Bank Credit
Cards," Economic Perspectives. Federal
Reserve Bank of Chicago, March-April
1987, pp. 3-13. The authors found economies of scale in credit-card operations for
a sample of small- and medium-size banks.
5. Figures are based on data provided by
banks participating in the Functional Cost
Analysis of the Federal Reserve System. For
a discussion of credit-card profitabiliry, see
Glenn Canner and James Fergus, "The
Effects on Consumers and Creditors of
Proposed Ceilings on Credit Card Interest
Rates," Staff Study 154, Board of Governors
of the Federal Reserve System, October
1987.

6. Peter S. Rose, "The Promise and the
Peril," The Canadian Banker & ICB
Review, Volume 85, November 6,
December 1978, pp. 64-65, and Joel P.
Friedman, "Golden Goose or Ugly Duckling?," ABA Banking journal, September
1986, pp. 73-77.
7. The Consumer Protection Act (October
1970) also limited the cardholder's legal
liabiliry for unauthorized use of the card
to a maximum of S50.
8. "Sears Is Discovering Discover Credit
Card Isn't Hitting Pay Dirt," Wall Street
journal, February 10, 1988, p. 1.
9. Kathleen Hawk, "Plastic Warfare," U.S.
Banker, June 1987, p. 40.
10. Delinquencies,
or past due loans, are
another measure of loan qualiry, but some
of these figures are treated as confidential
by bank regulations.
11. A list of so-called credit-card banks is
provided by the American Banker, January
4, 1988, p. 15.
12. The weighted average net charge-off
rate was 3.4 percent for the sample.
13. Credit-card charge-off rates were
regressed on the six variables listed in the
table. Each of the variables except creditcard balances was positively and statistically related to credit-card charge-offs at
least at the 5 percent level of significance.
The variables collectively explained 40
percent of the variance in the credit-card
charge-off rates across the 148 banking
organizations that were examined.

BULK RATE

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

U.S.Postage Paid
Cleveland, OH
Permit No. 385

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44101

-

CHART 3 CREDIT-CARD REVENUE BY CHARGE-OFF GROUPS
(AS A PERCENT OF CREDIT-CARD AVERAGE BAlANCES)
Revenue
2 0-

19.3

18-

17.4
16.9
16.2

1
6-

14.9

1
4-

~
0

Less than 1

1.0-1.9

2.0-2.9

3.0-3.9

4.0-8.9

Net charge-offs
NOTE: Based on 1986 data from reports of income and condition for bank sample.

charge-offs, therefore, do not necessarily imply inferior performance or
cause for immediate concern, as long
as lenders are being adequately compensated for credit risk.
The strong positive relationship
between revenues and charge-offs is
also depicted in chart 3. The chart
shows average credit-card revenues
for the whole bank sample broken
out into five groups according to the
level of credit-card charge-offs. Banks
in the higher charge-off groups progressively earned higher revenues,
suggesting that they charge higher
rates and fees but lend to riskier
customers.
However, the loan-quality/revenue
relationship could be spurious, that
is, other factors could be causing it.
When we isolated the influence of
individual factors while taking into
account other factors, such as asset
size and the percentage of loans in
credit-card balances, we still found
that banking organizations with higher
credit-card charge-offs had significantly higher credit-card revenues.

Other results were also similar to the
findings listed in the table." One
important exception was that creditcard balances were found to be negatively related to charge-off rates when
asset size was taken into account.
This finding, although statistically
Insignificant, is consistent with the
view that larger portfolios are generally more diversified and carry less
risk than smaller portfolios.
• Conclusion
Bank credit-card lending has
increased rapidly since the early
1980s.This increase has been fueled
by a range of factors, including robust
consumer demand, improved technology, removal or relaxation of state
usury laws, economies of scale, crossselling potential, substantial decline
in funding cost and attractive profit
margins. Higher credit-card earnings
have attracted new competitors, more
aggressive marketing and more liberal credit standards that, in turn, led
to a sharp rise in credit-card losses.

Credit-card charge-offsvaried considerably among issuers. Banks with higher
propensities to take risk incurred
higher charge-off rates. As long as
issuers receive adequate compensation for credit risk, however, chargeoffs are not necessarily a problem.
Also, the potential impact of high
credit-card charge-offs on the financial
condition of banks is reduced by the
fact that even the most aggressive
banks in credit-card lending still have
relatively small portions of their assets
and loans in credit-card receivables.

-

Paul R. Watro is an economist at the Federal
Reserve Bank of Cleveland.
The author
would like to thank john M Davis, Mark S.
Sniderrnan, andjamesB.
Tbomson for belpful comments. Research assistance was provided by john N. McElravey and Daniel].
Martin.
The views stated herein are those of the
author and not necessarily those of the Federal Reseroe Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.

•

Footnotes

1. See K.]. Kowalewski, "Is the Consumer
Overextended?,"
Economic Commentary,
Federal Reserve Bank of Cleveland,
November 1986.
2. However, this does not necessarily
explain why credit-card rates have not
fallen in tandem with other loan rates.
3. There are approximately 3,000 banks
and other institutions that issue credit
cards. "Interest Rate Controls on Credit
Cards - An Economic Analysis," Lexicon,
Inc., October 1985.
4. See Christine Pavel and Paula Binkley,
"Costs and Competition in Bank Credit
Cards," Economic Perspectives. Federal
Reserve Bank of Chicago, March-April
1987, pp. 3-13. The authors found economies of scale in credit-card operations for
a sample of small- and medium-size banks.
5. Figures are based on data provided by
banks participating in the Functional Cost
Analysis of the Federal Reserve System. For
a discussion of credit-card profitabiliry, see
Glenn Canner and James Fergus, "The
Effects on Consumers and Creditors of
Proposed Ceilings on Credit Card Interest
Rates," Staff Study 154, Board of Governors
of the Federal Reserve System, October
1987.

6. Peter S. Rose, "The Promise and the
Peril," The Canadian Banker & ICB
Review, Volume 85, November 6,
December 1978, pp. 64-65, and Joel P.
Friedman, "Golden Goose or Ugly Duckling?," ABA Banking journal, September
1986, pp. 73-77.
7. The Consumer Protection Act (October
1970) also limited the cardholder's legal
liabiliry for unauthorized use of the card
to a maximum of S50.
8. "Sears Is Discovering Discover Credit
Card Isn't Hitting Pay Dirt," Wall Street
journal, February 10, 1988, p. 1.
9. Kathleen Hawk, "Plastic Warfare," U.S.
Banker, June 1987, p. 40.
10. Delinquencies,
or past due loans, are
another measure of loan qualiry, but some
of these figures are treated as confidential
by bank regulations.
11. A list of so-called credit-card banks is
provided by the American Banker, January
4, 1988, p. 15.
12. The weighted average net charge-off
rate was 3.4 percent for the sample.
13. Credit-card charge-off rates were
regressed on the six variables listed in the
table. Each of the variables except creditcard balances was positively and statistically related to credit-card charge-offs at
least at the 5 percent level of significance.
The variables collectively explained 40
percent of the variance in the credit-card
charge-off rates across the 148 banking
organizations that were examined.

BULK RATE

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

U.S.Postage Paid
Cleveland, OH
Permit No. 385

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44101