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Consumer Debt Crisis Part 2
Originally published June 13, 2006
Page 1
Banks struggled with profitability throughout the early days of the credit card. Although it would one day prove to be a highly lucrative business model, the early systems were plagued with bottlenecks, costly processing and an inadequate consumer base. The overall lines of attack took several forms. First, they all invested heavily to increase efficiency at the point of sale, which had been a tremendous bottleneck in the early years. Large investments in computerization and electronic linking paid off as processing times plunged, making the card much more competitive with cash in terms of convenience. Second, they constantly lobbied legislatures to raise the state limits on allowable interest rates. Usually referred to as “usury ceilings”, these mandated caps sought to protect consumers from unfair lending practices. Unfortunately - at least so far as the credit card companies saw it - the rates were much too low. For example, in New York, the maximum allowable was 12% after the first $500. In the 1970s, as the discount rate took off to compensate for inflation, the spread between the bankʼs cost of money and the rates received by customers was sometimes as low as 3%. Including the inherent costs of maintaining the system, it was undoubtedly quite difficult to generate a profit. During this time only Bank America was consistently making money from its card operations.
The industry received a tremendous break from an unlikely source in 1978 when the U.S. Supreme court ruled in Marqette v. First Omaha Services that it was legal for nationally chartered banks to “export” their rates to the consumer, irrespective of indigenous laws. The implications didnʼt go unnoticed by the major bank executives. As one Citibank executive explained quite bluntly, “we realized that we could choose our headquarters state based on its usury laws.” (Manning, p. 88). Which is precisely what they did. Almost immediately, Citibank began negotiating with South Dakota - a state with an allowable rate as high as 24% - to weaken their consumer lending regulations still more. By early 1981 Citicorp had moved its headquarters from NewYork to Sioux Falls. Even today it remains the largest employer in the city.
But another important element of their strategy was to attract a new breed of card user. Traditionally the focus was on affluent, middle-class households which offered minimal risk. This was clearly reflected in a study conducted by Lewis Mandell in 1970. He found that fully 81% of families with an income of $25,000 or more used credit cards while less than 20% of those under the $25,000 annual salary level did so. Not surprisingly, the wealthy customers tended to pay off their balance in full by the end of the month and so incurred few finance charges. To industry insiders these customers were deemed “deadbeats” since they produced processing costs for the company, but never wound up paying finance charges. Citibank was particularly influential in making a demographic switch to lower income, higher risk consumers. This was in part because of Citibankʼs tremendous struggle with profitability in its credit card division throughout most of the 1970s. In fact Citibank lost nearly $100 million between 1970 and 1976. Executives reasoned that there was little to be lost by attempting the switch to a lower socioeconomic target. They hoped that a larger percentage of the cardholders would fail to pay some of the total balance and “revolve” it instead.
There are several factors leading to Citibankʼs eventual success so we canʼt argue that all of the profits which would eventually accrue to the corporation are due to the change in demographic target. Shrewd tactics certainly played a part. For example, in one mass mailing, Citibank beat Bank America to the punch when the name was being changed from Bank Americard to Visa. (At that point Bank America was licensing the card “brand” to qualified banks who were willing to pay the requisite fees.) Citibank made a pre-emptive mail drop to 30 million customers in advance of the change betting that customers would fail to notice they were actually changing the bank of issue. They were right. In fact, few card holders were even aware of which bank had actually issued the card, and assumed that they were simply filling out the requisite paperwork to get a card with the updated name. In fact they were really changing to a new issuing bank: Citibank. This single move yielded 3 million new customers. But hand in hand with these campaigns was the strategic targeting of lower income groups which had previously been ignored. In any event, by the end of the decade Citicorp was the largest single bank card issuer in the world.
In targeting lower income groups Citibank was going up against a lot of social inertia. Not only were such groups considered higher risk, there may have been a sense of civic duty to spare less affluent consumers the strains of costly credit terms. A good example of this was the initial resistance to pushing cards on student populations. In the early days of the credit card industry, executives openly dismissed the idea of marketing to student populations. Students were considered high risk candidates and there seemed to be a sense that they were in a formative stage and might not be inclined to use their credit wisely. Yet such compunctions were cast aside in the late 1980s in the wake of banking deregulation. Mounting financial losses in the recession of 1990 - 1992 helped to justify this move, and Citibank led the charge. Soon companies were renting solicitation tables on campus, funding student activities, and offering special college “branded” credit cards. As the strategies became more sophisticated, banks began sponsoring smart cards which were given multiple functions. The same electronic “key” needed to enter the dorm and obtain food at the dining hall might serve an auxiliary function as a bank credit card. This further tended to legitimize the use of credit, since the charge card was integrated fully into the required card for use in normal student activities. Clearly such strategies were effective.
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