Imagine you are the CEO of a small department store chain, competing against national retailers.
Although you carry a fairly complete line of products, your customers are clamoring for you to add home appliances to your mix. So you strike a deal with a national retailer to provide you with appliances you can sell under your brand name.
The national retailer will handle all service contracts and support all warranties. In return, you agree to provide your customer list for an aggressive direct mail and telemarketing campaign to promote your new private-label products.
But there is nothing in the agreement to prevent the national retailer from marketing its other products and services directly to your customers.
Absurd as this sounds, it is precisely the type of arrangement many banks are agreeing to as a way to enter or expand into the credit card business.
The outsourcing agreements that an alarming number of small and medium- size banks are signing with credit card specialists are decidedly not in the banks' best interests. Although these banks think their contractors are allies, they are in fact predatory competitors with inherent conflicts of interest.
One of the most common types of outsourcing is the correspondent relationship. A bank retains a credit card specialist to market and issue cards to its customers. Though the specialist assumes most, if not all, of the credit risk, it also retains the lion's share of the program's profits. What's more, it gains access to one of the client's most valuable assets - its customer list.
Why is this dangerous?
For starters, the major credit card specialists are no longer strictly in the card business. Many are publicly traded companies under pressure from Wall Street to offer a more diverse product line, including automobile loans and leases, home equity loans, and mortgages.
Many institutions that offer correspondent card programs also are among the highest payers of interest on deposits. Once a customer becomes accustomed to doing business with the credit card issuer, he or she will also consider doing other types of business with the issuer, thus bypassing the correspondent institution. That customer is likely lost to the correspondent, possibly forever.
Moreover, the economics of many correspondent outsourcing agreements are weighted heavily in favor of the issuing specialists.
Managed properly, a credit card program can be one of the highest- yielding assets in the prime consumer lending market. But many banks are shortchanged under their agreements with major issuers.
A correspondent bank can estimate account profitability and calculate if it will be compensated fairly. It can start by reviewing the financial statements of the credit card monoliths that offer correspondent services. Divide their net income by the number of accounts they service. Although this method is somewhat simplistic, it will give a reasonable estimate of account profitability.
More often than not, the correspondent bank will see that its own compensation would be less than 10% of account profitability - hardly a fair return for turning over a customer list.
A client should own the total income stream, and should pay only for services used. Furthermore, a quality servicer does not offer other services to a client's customers unless the client asks it to do so.
A servicer should not be competing with its clients or own a credit card portfolio; servicing should be its only source of income.
In another type of outsourcing, the issuing institution allows the correspondent to assume all, or part, of the profit and risk of the portfolio issued in its name. Although a measurable improvement over the pure correspondent option, it has its weaknesses. The issuing institutions that have announced this service reportedly have not shown a willingness to share much of their industry knowledge with their clients.
The primary concerns of these institutions are to issue and service credit card accounts for their own book of business and manage this process to maximize corporate profitability and shareholders' value.
In good times, this type of arrangement may produce very good services for clients. However, when the issuing institution's earnings come under pressure for any reason - and they inevitably will - it will be forced to concentrate on its own portfolio, not a client's.
Additionally, the companies offering this service are very active in the credit card solicitation marketplace, because they have to constantly expand their portfolios to meet the expectations of shareholders.
Given the fierce competition for credit cards, and the fact that these institutions' investors expect them to perform for their own book of business, why would they cede some of their customers or expertise to a client?
If they keep their expertise and all the accounts for themselves, they are not serving their clients very well. If they share with clients, they are not serving their shareholders very well.
Now, I am not a disinterested observer. My company specializes in credit card outsourcing and competes increasingly against the monoliths. And we concluded that we could not develop and manage card programs for others while still owning a credit card portfolio.
We believed we could not serve our customers, clients, and shareholders effectively with two strategies clearly in conflict with each other.
Given credit card yields, the desire to get into or expand in this business is understandable. And bankers can certainly establish profitable credit card operations by using the same cautious, informed approach they use in making other business decisions.
Of if you'd rather not do your homework, consider selling home appliances. Just contact a national retailer. I know of at least one that would love to get its hands on bank credit card customer lists.
Mr. Palombi is president and chief executive officer of Republic Services, a credit card outsourcing company in Columbia, S.C.