Troubled since 2005, the UK credit card industry has been suffering a severe test of profitability. But credit card issuers are hoping to rejuvenate the industry by moving to a more convenience-focused, sustainable and transparent business model.

The credit card industry has endured a torrid time of late but, unlike other financial services, these woes began well before the credit crunch and subsequent financial crisis. According to figures provided by the UK Cards Association (UKCA), an industry body that represents the card issuers operating in the UK, the troubles started in 2005. Until this point, key parameters such as the number of cards in circulation and the value and volume of transactions had enjoyed regular annual growth of between 5% and 10%. But then the market suddenly stagnated and has remained that way ever since.

The UKCA's head of card payments, Paul Rodford, says that it is difficult to pinpoint any single reason for the 2005 slump, though he feels that a sustained period of negative media coverage was highly influential. The record profits of the high street banks were juxtaposed with unprecedented levels of consumer debt, while the UK press reported on a series of suicides brought on by six-figure credit card arrears. And in 2003 a Treasury Select Committee hearing, convened to grill the heads of the four major high street banks about their practices, embarrassed the then chairman of Barclays, Matt Barrett, after he confessed that he would never consider borrowing on a Barclaycard because it was too expensive.

A cooling passion

The financial crisis has only exacerbated the situation. A report into the UK's consumer credit market from PricewaterhouseCoopers (PwC) entitled Precious Plastic, described 2009 as a watershed year with both lenders and borrowers assessing their balance sheets. While total household borrowing has remained constant during 2009 at approximately £1500bn ($2240bn), there has been a cooling passion for plastic. The report cites a 3% drop in the level of credit card borrowing to £64bn, an 8% drop in the number of cards in circulation, and a rise in bad debts accounting for almost 6% of outstanding balances that could conceivably rise to 9% by the end of 2010 - something which the report states could have enormous implications for the profitability of credit cards in the UK market. "Large scale change within the sector over the next few years is inevitable," says Richard Thompson, a partner at PwC and author of the report.

Much of this change is likely to centre on the reinvention of the credit card as a means of payment rather than a borrowing tool. Mr Thompson says: "I think the old credit card model is being called into question and the industry needs to get away from its current image. It needs to get back to basics and to concentrate on payments. I think the credit card providers that look at innovative ways of paying - contactless payments and mobile payments - will be the ones that are more successful. Rather than making their money from interest charges, credit card providers should be looking to profit from the convenience that their payment tools provide."

The focus on payments rather than credit may represent greater long-term prospects for card issuers but they will have to cope with greatly reduced margins. The European Commission is demanding a reduction in interchange fees (the fee paid by the acquiring bank to the issuing bank for every card-based transaction) due to allegations of price-fixing. Payment protection insurance has also become a less profitable business for card providers and default fees have been capped at £12, as opposed to the £20 to £30 they were previously.

"So in effect, the only sustainable revenue stream for the card providers is the interest fees and charges," says Mr Rodford. There is always the possibility of introducing annual fees and new charges but whoever goes first will likely suffer the first-mover disadvantage while leaving the door open for others to follow suit, except without the blaze of negative publicity that dogged the first mover. There is also the fact that an addition of an annual fee will not affect interest rates but the annual percentage rate will increase by 2% or 3% overnight, making it appear less competitive.

Regulatory burden

UK credit card providers also face a significant regulatory burden in the next year. A consultation process between card issuers and the UK government's Department for Business, Innovation and Skills was started in October 2009, designed to bring more simplicity and transparency to the market. The card companies must now start delivering on any promises made during the consultation. However, they also have to comply with the Consumer Credit Directive, the Consumer Credit Act, the EU's Payment Services Directive and the Office of Fair Trading Irresponsible Lending Guidance among other peripheral measures.

"There is an enormous amount of regulation at the moment and the outcome of it all is still to be seen... It is up in the air what the industry will look like in 12 months," says Mr Rodford. With the cost of compliance going up as revenues and margins go down, credit card providers will find it harder to stay in the market and many are selling off their portfolios. For example, General Electric sold its book to American Express and Santander; Alliance & Leicester sold its book to Santander; and Citi sold its book to SAV, which is part of HBOS. The major credit card providers declined to comment.

The use of technology is also likely to play a significant role in the attempt to switch the focus from credit to payments. According to Steve Perry, commercial director at Visa Europe, there has been a big push in contactless payments. At the moment, the payments are limited to £15 and are geared around those retail environments where speed of service is vital - hence the current focus on coffee houses and sandwich shops. As consumers' confidence in using contactless payments increases and their fears over security subside, the limit may rise (the US is already experimenting with £100 payments).

Mr Perry believes there have been some significant inflection points in terms of the public's attitude to payments. "As a result of the crisis, people have become cannier," he says. For example, he points to the greater use of the internet to make payments. "Consumers are going to the shops to look at the items they want and get a literal feel of them before going on the internet to search for the cheapest supplier." Mr Perry adds that he is seeing a greater number of payments but of less value, what is often called 'the lipstick economy'. "Essentially there is less impulsive buying and more considered purchasing," he says.

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Egg chief executive, Bert Pijls

Convenience, not credit

By focusing on the card as a means of payment and not a source of credit, the card companies will be adapting to changing customer behaviour and adopting a less risky business model, particularly in the current, credit-averse consumer climate. But it is a business model that will generate less revenue. "It is clear that credit card companies were making more money five years ago than they are today," says Mr Perry. "But I don't think it is necessarily about a trade-off between payments and lines of credit. The ability to make money from lines of credit is restricted because of the lack of consumer appetite, so what the banks have to do is take cost out of the system by persuading consumers to use payment cards instead of cash and cheques. This appears to be the strategy of most banks and it is one I fully support."

In 2009, online-only credit card provider Egg launched a new product called Egg Money, which offers customers 1% cashback on all of their purchases as well as insurance coverage for various purchases - entertainment events and travel, for example. The biggest change, however, may be the fact that the card has a £1-a-month fee. "I believe it is a much more transparent pricing model rather than pretending that financial services are free," says Egg chief executive Bert Pijls. "There seems to be this notion that banking is free because many products do not have a fee or have a 0% interest rate. Instead we are saying that if you pay us £1 a month, in return you will get a set of insurances and cashback on your purchases."

Egg's focus for the future is not only about making the card an attractive payments vehicle rather than a convenient line of credit, but also about encouraging more responsible borrowing from its customers, says Mr Pijls. "As credit card providers, one of our objectives needs to be helping customers manage their debts more efficiently and effectively than we perhaps have in the past. We need to provide more transparent information so that customers can see the costs of their debts and can see the effect of habitually making the minimum payment. Credit cards need to be a good idea again rather than dangerous instruments that can lead to debt being out of control."

Mr Pijls adds that the industry needs to consider the role that introductory offers play within that scenario. "This market is very much led by zero balance transfer offers. The problem with this offer is that it gives no incentive for repaying debt." A decade of zero balance transfer offers has resulted from the aggressive efforts of the card providers to acquire customers. But, in the wake of the credit crisis, bigger players such as high street banks are starting to concentrate on getting more revenue from existing customers rather than seeking new ones.

Changing behaviour

New regulation and the switch from low- to high-payment hierarchies, whereby the most expensive debts are paid off first, will be influential in terms of card providers' use of introductory offers, according to Mr Pijls. "This switch will make it more difficult for [card providers] to offer aggressive and long-lasting zero balance transfer offers. Consequently we may see a reduction in the duration of these offers and the aggressive use of interest rates. It may seem counter-intuitive but if this means we get to a more balanced position where customers are better able to pay off that debt, then I think it is a better place to be," he says.

Mr Pijls is encouraged by what he sees as a change in customers' behaviour towards debt in the aftermath of the credit crisis. "In the past, when in a recession, some consumers have indulged in runaway debt but we haven't seen that. The spending habits have changed very little but there has been a big change in repayment habits." This may be due to low mortgage interest rates that afford borrowers more funds to pay off their credit cards. Whatever the reasons, this more responsible attitude to debt is welcomed by Mr Pijls. He says: "On the one hand, it means that my outstanding balances are reducing, making it difficult to generate the same revenues, but that is better than having consumers spending more, paying back less and getting into financial difficulty."

Risk exploitation

There is also some evidence that credit card providers are exploiting more rigorous risk management practices. For example, HSBC has teamed up with UK-based property research and database company Hometrack and others to produce a tool called Equity Indicator, which takes all of the debts that a customer has (not just their mortgage) to produce a more comprehensive credit evaluation. "A bank may have only one relationship with a customer so this gives it a more complete picture such as the changing value of a customer's property and whether they have met all of their monthly credit agreements," says Gary Styles, director of strategy, risk and economics at Hometrack.

Mr Styles hopes that the product will be particularly popular with the monoline lenders that have little information on customers and he is also confident that the interest in greater risk management will remain once prosperity returns. "I think it will be a permanent change. There are different risk characteristics in loan-value levels and they should be factored into lending decisions," he says.

This theory could be tested sooner rather than later. In the US, two of the major credit card providers have just announced first-quarter 2010 earnings that exceeded analysts' expectations. American Express posted shareholder profits of $873m, up from $361m for the same period in 2009. Meanwhile, Capital One, which is acknowledged to have a more penalty fee-led business model, saw its first quarter profits rise to $636.3m against a loss of $172.3m in Q1 2009. And despite the industry's talk of eliminating dangerously unsustainable introductory offers, the UK market recently saw the launch of a 0% balance transfer card from Clydesdale and Yorkshire banks lasting 16 months, outstretching the previous longest offer of 14 months from Virgin Money.

The credit card issuers' position may be strengthened by an increasing demand for credit at a time when it is in short supply. But consumers remain wary of the pricey credit card providers, and the true test of the industry's new, transparent, sustainable, fair and responsible business model is yet to come. But the likes of Egg's Mr Pijls are confident that both customer behaviour and providers' business models should endure, even when the economic climate improves. "Everybody has learned from the past two years. As a chief executive, I've learned a lot and I think we will see more responsible behaviour from every stakeholder in the industry."

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