The sudden onset of price competition in the US Credit Card Industry.

Author:Schumann, Hans O.
Position::Abstract
 
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INTRODUCTION

Up until the early 1990s, The American Credit Card industry has attracted a significant amount of academic interest and articles published in economic journals. Academics, led by Ausebel (1991), Calem (1992), and others, focused on the fact that for decades the industry showed very little of the competitive price competition that one would expect from of an industry with thousands of firms selling an essentially homogeneous product (1). In 1992, the competitive market-defying interest rate "Stickiness" abruptly changed. Almost overnight, the industry became a fiercely contested market using interest rate pricing as its main competitive weapon. The purpose of this article is to explain the unique factors that all converged in 1992 to cause this momentous shift. There were three forces that worked together to change the competitive paradigm--The unique characteristics of the 1990-1992 recession; the U.S. presidential election campaign with its focus on health care reform; and the variable interest rate structure that had previously been adopted by some issuers including First Chicago Corporation and AT&T Universal Card. The catalyst that provided the spark that changed this industry was the health care insurance reform debate which was part of the 1992 presidential campaign. The net result of all these forces, triggered by the health care debate, was an awakening of the cardholders' recognition of their true financial situation. This directly resulted in the fundamental reformulation of the consumers' desire to negotiate and shop for credit cards with lower interest rates. During the year 1992, credit card interest rates ceased being "sticky" and serious price competition entered this industry where it had never been before.

HISTORY OF THE INDUSTRY

The general purpose credit card industry has a long history in the United States. Merchant credit has been extended in one way or another since the nineteenth century. Early in the twentieth century hotels and department stores began issuing identification cards for their best customers, thereby alerting the merchants' staff that these customers should be extended credit if requested. Diners Club in 1949 developed the first general purpose charge card. Together with American Express, they focused primarily on relatively wealthy customers and enabling travel and entertainment purchases. In the late 1950's Bank of America launched the bank-run credit card industry we know today with the BankAmericard. By franchising this concept to banks in other geographic regions, Bank of America created an organization that would later morph into what is now known as Visa, USA. Their principle competitor, MasterCard, then known as MasterCharge, was established in 1966 (2).

By the 1980s, the American general purpose credit card industry consisted of over 4,000 banks and bank-owned credit card issuers offering products through two industry associations, VISA and MasterCard. The largest bank card issuers included most major US money center banks: Citicorp, Chase Manhattan and Bank of America. In 1986, Sears Roebuck & Co. entered the general purpose credit card industry by creating its own Discover brand card and merchant card acceptance network. One year later, American Express entered the credit card industry with their Optima credit card utilizing their American Express Charge Card's merchant network. In 1990, the US telephone giant AT&T through a partnership with Total Systems Corporation entered the industry and began issuing MasterCard and Visa Cards. General Motors in a partnership with Household Finance entered the industry late in the fall of 1992.

This is an industry selling an almost identical product with a very large number of firms and a proven ability for new entrants to enter. In other words, this is an industry that economists would normally expect to classify as "pure competition." Yet despite all of this competition, the credit card interest rates, as measured by the Annualized Percentage Rate (APR), remained high throughout the 1980s.

Bank card issuers primarily earn their revenue from two major sources, fees from merchants (interchange fees) and the interest charged to revolvers (finance charges). The base interchange fee level and structure is set by the Visa and MasterCard associations; the finance charge fee structure is determined by the individual card issuer. Historically, issuers offer the cardholder a monthly grace period. Should the cardholder pay the entire statement balance within that grace period, no finance charge will be assessed. If the entire balance is not paid, the cardholder agrees that he has taken a loan, and interest charges begin to accrue. Augmenting interchange and finance charges, card issuers also can earn incremental revenue through the imposition of annual and/or other fees.

In addition to the internal competition in the bank credit card industry, there was additional competition from the firms active in the related retail store charge card (Sears, JCPenney, etc.) and travel and entertainment card (American Express, Diners Club) industries.

The retail store charge card industry differs from their general purpose cousins in the inability of cardholders to use the credit they offer at any other store other than the issuer. The dual purpose of these retail programs is to both generate finance charges as well as to increase retail sales for that particular merchant. The travel and entertainment card industry is different from the general purpose card industry in that cardholders do not have a "preset" spending limit, but cardholders are required to pay their charges in full upon receipt of their monthly statement. Without a consumer financing facility, these issuers lack a consumer interest revenue stream and are thus more dependent upon a higher merchant interchange fee.

TYPES OF PARTICIPANTS

Individual credit cardholders can be categorized as either "transactors" or "revolvers". Transactors typically pay off their balances each month, and thus they generally do not incur finance charges. As these customers do not finance their balances, the credit card's APR is typically irrelevant to them. Revolvers are those customers who do carry a balance from month- to-month, and are thus subject to credit card finance charges. As such, one would expect a card's interest rate to be relevant to these customers.

Card members generally make a decision to initially become a revolver in one of two ways. They either make the decision that they will use the credit card to finance a product at the point of purchase, or they decide to become a revolver and carry a balance at the time the credit card statement is being paid. In the first instance, a customer is making a purchase that they are aware that they will be financing. In that case, they use the card knowing that their current purchase will not be paid for in full this month, but that instead they will need to pay for this expense out of a future paycheck or paychecks. They realize that they are buying a product that they cannot afford based upon the current month's cash flows. In essence, a cardholder making such a purchase is making the trade-off of the earlier enjoyment, (and in the case of durable goods--extended enjoyment), or is taking advantage of a product offer that they may feel might not be available at a later date. If the extra benefit of an early purchase outweighs the expected finance charge, the use of a credit card financing is a logical decision.

In the second case, "revolvers" become revolvers because of external events, emergency spending needs, or poor budgeting. In these cases, the credit card bill is one of the few monthly obligations that not only allows the customer to not pay the bill in full, but that actually encourages it. For both types of customers, the credit card, with its pre-approved credit limit serves and additional third purpose--an emergency line of credit which can be used as a substitute for a "rainy day" savings account.

DISTRIBUTION METHODS

The main marketing and acquisition method for credit card accounts has been historically though solicitations delivered through direct mail. Direct mail has the advantage of being able to target the offer to individuals and the ability to use pre-screened list of potential customers from the operators of the three major US credit bureaus. Prior to 1992, the focus and messages of these direct mail solicitations were on any "pre-approved" status of the offer, the credit...

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