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This story appears in the August 2009 issue of Cards&Payments.
The science of credit card risk management has become significantly more complex in the past year with the combination of record-breaking charge-off rates and new U.S. card-industry regulations affecting risk-based pricing approaching fast.
The economic downturn is adding to these pressures by depressing card-industry profits, which is limiting issuers' ability to invest in additional personnel and new technology to evaluate new and existing cardholders' creditworthiness.
Risk managers are coping by tightening their underwriting criteria, tweaking existing risk-management tools and technology while huddling with management and legal counselors to shape new credit card terms and policies to comply with the Credit Card Accountability, Responsibility and Disclosure Act. Signed into law last May, most of the act's provisions go into effect in February, with far-reaching implications for credit card risk-management policies.
A key provision of the act restricts card issuers' abilities to raise borrowers' interest rates based on risky behavior such as missing payments and exceeding individual borrowing limits, eliminating one of the main tools issuers have used to manage card customer risks that can lead to losses.
"The provisions of the law pretty much amount to an outright ban on risk-based interest-rate changes, which means issuers are going to have to be a lot more strategic and creative about how they manage underwriting on the front end when they book a new account," says Michael Brauneis, a director of regulatory risk consulting at the consultancy Protiviti Inc. "There will be no safety net, so issuers must settle on an appropriate interest rate based on the individual customer's risk profile at the time the account is opened and stick with it for awhile."
Among other things, the act bans changes to credit card interest rates on existing balances except when a cardholder is more than 60 days late paying a credit card bill or in certain other special circumstances. Interest rates offered to customers cannot be increased within the first 12 months of establishing the account, and promotional rates must endure for at least six months. And beginning this month, issuers must notify cardholders 45 days in advance of any major changes in card terms, which further complicates their task of managing individual cardholder risk.
These new rules represent a sharp departure from many large card issuers' existing marketing strategies, which for years centered on luring in new customers with short-term 0% or low-interest rate offers, then raising rates when the promotion period expired. Many issuers also habitually have increased interest rates when cardholders were late by just a few days with payments or have maximized their credit limits to protect themselves from the greater risk of default such cardholder behavior poses and to offset losses.
In the new climate, managing the risk surrounding new and existing customers–and marketing cards with terms issuers can sustain–has become much trickier, analysts say. Not surprisingly, for the moment issuers have pulled back on direct-mail offers for mainstream credit cards as they regroup in anticipation of the new card-industry regulations, says Brian Riley, a research director at TowerGroup, an independent research firm owned by MasterCard Advisors.
'Reluctant To Commit'
"Direct-mail offers typically have a long lead time for development, and when issuers are not sure where their terms are going to settle in, they are reluctant to commit to terms in mailed offers," he says. "While issuers can never completely shut down their acquisition engines because that will hurt them further down the road, they are being very cautious about who they are approving for new accounts this year."
In-branch and Web site card-marketing efforts this year have gained popularity among issuers acquiring new customers, Riley says. "Cross-selling credit cards to existing banking customers through in-branch marketing is the safest way to expand a card portfolio, and instant-decisioning through the Web or using live customer-service agents is not a bad route to go either, as long as issuers have good systems backing those decisions."
Issuers also are looking for ways to improve the accuracy and to speed up the process of approving new card customers, even within tighter underwriting criteria. On its Web site last month, Discover Financial Services continued to tout balance-transfer offers that would stay at a 0% annual percentage rate for nine months "for customers with excellent credit." Moreover, Discover promises to give cardholders an approval decision on the Web within 60 seconds of filling out an online application.
While such instant-decisioning systems are not new, their ability to isolate the riskiest customers is continually improving, analysts say.
Indeed, clients are asking Zoot Enterprises Inc., which provides systems enabling instant credit decisions, for tools to enable risk-managers to develop, test and deploy new risk-management models in as little as one day. "Traditionally it takes days or months to develop and test new risk-management models, but recently we have sped up this process," says Eric Lindeen, Zoot director of marketing. "There is a new urgency among issuers to add flexibility and speed to their risk-management processes."
This month, Zoot unveils its Credit Risk Lab, a customizable desktop software product that enables issuers to develop their own risk-management models quickly by plugging in different variables and getting results back immediately. The new tool uses a graphical interface to define new variables and run an instant test to see if a certain risk model among specific sets of consumers would yield creditworthy prospects.
"The goal always is to find out the likelihood of a consumer defaulting on a new credit card account, and with this tool issuers can easily plug in performance data from the past six months and test scenarios," Lindeen says.
The Credit Risk Lab cost varies based on an issuer's scope and was developed for institutions that build their own risk policies, Lindeen says.
Preapproved or "prescreened" credit card offers are likely to change as issuers adjust to the new card regulations, Lindeen says.
"Preapproved offers have been around for years, but issuers have been adding stipulations that require a second credit check before approving the customer for a new card account," he says. Adding a second credit check creates "friction" in the process of approving new customers, and it may not comply with new credit card-industry regulations, Lindeen says.
To stay on atop compliance with the new rules, "issuers need to create and deploy risk models faster," he says. "This will also help them keep up with a dynamic model."
Once they have signed up new customers, issuers also are working to monitor their behavior from the outset of the relationship and catch them earlier in the delinquency stage, when an account is just a few days past due, contacting them for credit-counseling or early collection. Previously, issuers might have waited 10 days or even a few weeks before contacting a delinquent cardholder, says Rick Openshaw, a global solutions leader in the risk management practice of MasterCard Advisors, an independent consulting firm owned by MasterCard Worldwide.
Credit-Limit Alerts
"People become delinquent for a variety of reasons and will respond to intervention in different ways," Openshaw says. He recommends issuers add "capacity index" technology to their monitoring systems that can alert issuers when borrowers are nearing their credit limits.
"These tools are useful for predicting not only when an account is in danger of becoming delinquent, but what measures are likely to be most effective" in avoiding losses or restoring the customer to current status, Openshaw says.
Issuers are asking for increasingly specific risk-management data analysis, according to Michele Bodda, vice president of prospecting and acquisitions at Experian PLC, an Ireland-based credit bureau with operations in the U.S.
"Within the last year we have been able to store data using a more granular method so that instead of seeing that a prospective card customer recently applied for a loan, we can see exactly what type of business loan or type of mortgage a customer previously applied for. Our ability to pinpoint prospects' past behavior is constantly improving, and issuers are finding ways to plug that data into their models," Bodda says.
And direct-mail offers based on individual customers' risk profiles will make a comeback, Bodda says. "Direct mail is still the most effective way to get directly to a consumer, and issuers are going to find ways to be more efficient in using it," she says.
Many issuers are augmenting routine credit-scoring techniques with other credit scores.
VantageScore Solutions LLC in June announced that eight of the top 10 credit card issuers are now using the alternative credit-scoring model it launched three years ago to compete with Fair Isaac Corp.'s FICO score. A joint offering by Equifax Inc., Experian and TransUnion LLC, credit bureaus designed VantageScore to reduce inconsistency among credit scores by using more-similar criteria.
The economic downturn seems to have spurred more issuers to adopt the alternative score this year, says VantageScore CEO Barrett Burns.
"VantageScore was developed between 2003 and 2005, when issuers were scoring a wider variety of prospective borrowers than ever, which laid a foundation for scoring more-diverse consumers during economically volatile periods," he says.
VantageScore enables issuers to evaluate more customer prospects by examining two years' worth of consumer borrowing and repayment behavior, which FICO does not necessarily provide, Burns says. VantageScore also goes further than FICO in documenting thin-file financial activity among prospective borrowers, he adds.
"During this (economic) crunch, issuers want to score more people and at the same time remain very accurate in measuring the likelihood of borrowers defaulting within 90 days," Burns says. "Issuers want to expand their universe of borrowers without being forced to loosen their credit criteria."
The new card-industry regulations will have a significant effect on credit card issuers' risk-management practices. With limited time and resources, issuers are making rapid adjustments while exercising caution about extending credit to new customers and managing those already in their portfolios. CP
