A key measure of profitability at banks' credit card operations plummeted last year to its lowest level in more than two decades, though these units continued to outperform the rest of the industry, according to the Federal Reserve.
The card sector's profitability is coming under pressure from federal regulations issued in December and a law enacted last month. Both are scheduled to take effect next year and will likely shrink the market — and its potential returns.
But even before the government started clamping down, mounting chargeoffs had cut the return on assets at large U.S. "credit card banks" almost in half.
"They'll still be profitable, but far less profitable than what has been enjoyed in the past," said Robert Hammer, the chairman and chief executive of the card advisory firm R.K. Hammer in Thousand Oaks, Calif. The industry continues to suffer from "the difficult economy, which is still troughing up, consumers that are wary [of spending], regulations that are really hamstringing what issuers can do. … It's going to be a tough year."
The return on assets for credit card banks declined 132 basis points from 2007, to 1.43% last year, the Fed said in a report published last week. That's the lowest figure recorded since 1986, a few years before the Fed starting sending Congress an annual report on the profitability of banks' credit card operations. (The Fed defined credit card banks as those "established primarily to issue and service credit card accounts"; observers said that likely includes the card units of larger banking companies.)
"The 2008 rate of return is very low by historic standards; well below the average rate of return of 3.03% since 1986," the report said. "Much of the decline in net earnings can be traced to deterioration in credit quality."
The historical comparison is not exact, the report noted, because the ranks of credit card issuers have expanded and contracted since 1986. (The Fed report was based on data from 18 banks established "primarily to issue and service credit card accounts" with more than $200 million each in assets. At the end of last year, the report said, those 18 banks accounted for roughly 77% of credit card balances on the books of commercial banks or in securitized pools.)
Even after last year's drop in profitability, credit cards continue to perform better than most other parts of the banking sector, according to the Fed. "Credit card earnings have been consistently higher than returns on all commercial bank activities," the report said. For all commercial banks, return on assets plummeted 137 basis points from 2007, to a paltry 0.04% last year, the report said.
Observers said higher-than-average returns are necessary for card issuers to manage the risk of these unsecured loans.
"There's a long history of people who said, 'I'm going to do this, too,' and did it wrong, proving that there's a specialized skill set" to issuing cards, said Leigh Allen, the principal of the New York consulting firm Global Consumer Finance Advisory LLC. "The problem with most other banking products is it's far too easy for others to do, and the barrier to entry isn't there."
He pointed out that the card industry also has some flexibility in its overhead: though collections costs have risen in tandem with losses, for example, issuers have sharply cut back on direct mailings. The Fed report cited a survey by Synovate, a market research unit of Aegis Group PLC, that found direct mailings dropped to 3.8 billion in 2008, down by 1.4 billion from 2007.
Though the Fed report describes "recent regulatory actions" and "recent congressional actions," it does not forecast how they will affect the industry's returns.
Observers have predicted a negative impact, but said Monday that the sector should remain profitable — and will continue to outperform other banking products.
"While the industry is likely to be somewhat smaller and less profitable after new laws are put in place, we still believe credit cards will continue to provide one of the most lucrative returns of the asset classes within banks' portfolios," Sanjay Sakhrani, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., wrote to clients Monday. "From late February onward (when the guidelines of the law are implemented), we think it really comes down to where we are in the cycle as far as the extent of the impact the law will have on profitability."
He predicted that the industry could shrink as much as 20% to 30% from its peak, and estimated that its return on assets could fall by about 50 basis points. In an interview, Sakhrani said the average return on assets for the large issuers (including Citigroup Inc., Discover Financial Services and JPMorgan Chase & Co.) was closer to 2% last year than the Fed's figure. In addition, "provision levels were pretty high as issuers were building up reserves ahead of a deteriorating landscape" at the end of the year, he said. "I think that '1.43' was negatively impacted by that phenomena."
Despite ongoing losses and the new regulations, "the underpinnings of the industry are strong," he said. "You're still able to reprice, maybe not as dynamically as in the past, but there's still a fair amount of utility in the product and consumers are still going to want the product."