Like junkies with a habit that is spinning out of control, banks are hooked on the fat spreads to be made in consumer credit card lending. Craving the ever greater volume required to produce profitability, banks continue to madly solicit new credit card customers even as consumer bankruptcies hit an all-time high, eroding the banks' easy profits from underneath.

With unemployment hitting lows unseen in decades and the economy seemingly strong across many fronts, nobody is ready to claim the consumer credit sky is about to fall on credit card issuers. Yet, there have been disturbing signs. Advanta Corp. racked up stunning losses early this year following aggressive credit card solicitations. Since then, credit card solicitations industry-wide have hit record levels with 881 million solicitations mailed in the second quarter of 1997 alone, according to published reports.

The heated pace of solicitations suggests a frantic effort to maintain profits through volume. "While some credit card issuers are making very good profits, the overall profitability of credit cards is declining and has been doing so since 1993," reports Robert Heller, executive vice president, Fair, Isaac & Co., San Rafael, CA., a credit scoring and profitability analysis tool vendor. The culprit is competitive pressure, which has forced issuers to shave interest rates, make increasingly attractive introductory offers, and expand their search for more customers into the margins of creditworthiness.

recognizing the risk

By early November, Federal Reserve Board Governor Susan Phillips, speaking in Chicago at the Asset/Liability and Treasury Management Conference of the Bank Administration Institute, implicitly recognized the credit risk problem by calling for new approaches to credit risk management: "While industry efforts to quantify credit risks are still in the early stages of evolution, recent progress holds promise for reducing both institutional and systemic risks. Indeed, these efforts might eventually lead to new supervisory regimes for addressing credit risk"

The financial world, however, is not unanimous in its assessment of the state of consumer debt, which hit $1.229 trillion in outstanding credit in September, up from $1.177 trillion a year before. Different parties latch onto different sets of numbers to validate their take on what is happening. "Credit cards have caused some problems, but consumer debt as a percentage of total outstanding debt is lower," notes Jeff Norris, president and CEO, Affinity Technology Group Inc., Columbia, SC, a provider of financial decision support technology. He sees no reason to sound alarms.

"Yes there is a consumer credit problem," declares Warren Heller, research director, Veribanc Inc., a bank rating and research firm based in Wakefield, MA. But the problem, at least for now, is contained in the credit card area. As long as the bottom line-the profitability of the credit card business is strong for the issuer, high charge-offs are acceptable.

But as charge-offs proliferate, an individual card issuer reaches a point where profitability suffers. Advanta is an extreme example. Now, Heller suggests, "The credit card industry as a whole may have reached the point of diminishing returns."

"The delinquency figures have reached a plateau. We'll see the numbers bounce around at these levels, especially for credit cards," predicts James Chessen, chief economist, American Bankers Association, Washington. "Clearly many consumers are right at the edge in managing their finances, and some are falling over," he adds. The implications may be serious for some individual organizations, which will experience serious losses, "but it doesn't mean anything for the overall condition of the industry," Chessen concludes.

puzzling delinquencies

Others are more concerned. "Credit card charge-offs may have stabilized, but they are not heading down. Consumers have too much credit and are showing signs of stress," observes Tanya Azarchs, a director of financial institution rating at New York-based Standard & Poor's. "If the economy goes south, there could be real trouble," she points out.

It is the very strength of the economy that makes the record consumer bankruptcies, over 1.3 million by the end of 1997, and high levels of delinquencies so puzzling. With the lowest level of unemployment in over two decades and fairly stable, relatively low interest rates, consumers should be sitting pretty, not showing signs of stress.

Indeed, everyone's tune changes if the economy starts to weaken. "What happens in a downturn?" Veribanc's Heller asks. The simple answer is more Advantas, new record levels of consumer bankruptcy, and plummeting credit card profitability as well as a shakeout among the approximately 7000 card issuers.

But the ramifications aren't likely to be so clear cut. It really depends on specifically how the economy weakens, suggests Fair, Isaac's Heller. If interest rates rise, consumers with variable rate credit cards and loans will experience pain as payments rise along with interest rates. On the other hand, if the weakness produces higher unemployment, interest rates will drop, reducing the burden on those same credit card holders and consumer borrowers.

Despite the delinquencies and bankruptcies, nobody is suggesting that today's consumer credit problems will threaten the financial industry overall. "The industry is adding new capital and has ample reserves," insists Chessen.

But even those card issuers racking up big profits could be doing better. "Credit card issuers would be making a lot more money if they could scale back their losses," says Barbara Smiley, research director, Meridien Research, risk management services group, Needham, MA. But scaling back may require card issuers to be less aggressive-something the market does not reward.

Success in the credit card business is directly tied to scale. "You have to have high volume to make money," Veribanc's Heller explains. The charge- offs are acceptable only because the issuers can bring in large numbers of consumers willing to pay very high interest rates, at least after the initial introductory teaser rates expire. Between the use of automation to drive down costs and high interest and high fees to offset losses, the largest issuers stand the best chance of success.

The keys to winning in the credit card business, therefore, come down to reducing costs through automation while better managing the risks through new credit analysis methods. Meridien, in a recent report titled Consumer Credit Risk Management Technology, contends that automated credit decisioning technologies will streamline the credit process while assisting in managing risk and, ultimately, help banks survive.

Federal Reserve Governor Susan Phillips came down strongly on the side of new approaches to credit risk analysis and management: "We recognize the inadequacy of the existing risk-based capital regime where such assets as loans are all treated as having the same risk. We are actively encouraging the development of more quantitative approaches to credit risk management."

What the Federal Reserve is calling for goes beyond simply tweaking today's credit scoring models or credit management systems. Phillips appears to be suggesting a new portfolio approach to consumer credit by which risk management decisions are taken based on quantitative analysis of various subsets of the institution's entire consumer credit portfolio. Such an approach, for example, will allow managers to model and analyze the impact of an interest rate rise of a certain segment of the credit card portfolio.

Others suggest institutions simply need tools to manage the individual consumer's diverse credit relationships. "As banks get more of a customer's relationships, they can look at all of the issues, from credit cards to mortgages," says Bob Landry, group director/retail banking advisory services at the Tower Group, Newton, MA. Few banks, he adds, have tools to do this yet. New scoring models and tools will be required.

One thing is certain: the solution will not come from restraint on the part of the bank or the consumer. The institutions will keep soliciting for cards because "If an institution can make nine to ten points, it can take losses and still make big money," says Affinity's Norris.

In the end, "Banking is about risk management," Chessen points out. While new scoring models, credit management systems, relationship profitability systems, and portfolio risk analysis systems will help manage risk, there will always be losses. Today's consumer debt stress is just one more risk to be managed.

-radding tfn.com

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