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April 28, 2009

Fix a Credit Card Industry Gone Awry

Rita McGrath
Associate Professor, Management
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One of the companies I studied for my dissertation research, which dealt with how established companies build competences to tackle new areas, was Citibank (as it was then known). Citi was kind enough to sponsor my three-year research program on their corporate ventures that yielded many insights into the corporate venturing process (and which helped me get through graduate school). I studied their successes and the failures and tried to figure out what made the difference.

Ironically, one of Citibank’s major successes was its credit card division. In a plot with many twists and turns, I learned how Citibank had leveraged Bank of America’s marketing campaign to switch from BankAmericard to “Visa” by capitalizing on a mistake. Bank of America, which had convinced many customers that a Visa card was the next must-have financial product, proceeded to promise customers that they would indeed get their new Visa cards — but only when their current cards expired. By definition, half their target audience would have to wait six months or more! Citi put huge ads in the newspaper, promising that if customers applied for its Visa, they would get one immediately. The response was overwhelming — so much so that the resulting cash outflow nearly sunk the bank. The operational stress was legendary. Warehouses full of Christmas receipts were said to be still sitting around in February. Cleaning up the operations was what eventually set John Reed up to become the CEO of the bank.

An even bigger problem, however, was that bank regulation at the time (the 1970s) strictly limited how much interest could be charged on consumer credit. These regulations, called usury laws, were intended to help protect consumers from the rapacious behavior of people who would take advantage of them. But by 1980, the interest limits imposed by usury laws were lower than the rate of inflation. Citibank was being squeezed between New York state usury laws and double-digit inflation rates.

“You are lending money at 12 percent and paying 20 percent,” said Walter Wriston, then the CEO of Citi. “You don’t have to be Einstein to realize you’re out of business.”

Citi successfully lobbied the government of South Dakota for a deal. The company would bring thousands of well-paid white collar jobs to a state that was going through massive economic suffering in exchange for the ability to charge higher rates of interest on revolving credit card debt. Deal done, Citi moved, and the forces that shaped the way we use credit cards today were set in motion.

Amazingly, even when interest rates came down, consumers continued to pay high rates of interest on their cards. As I’ve argued elsewhere, the people that run credit card companies must be the smartest behavioral economists in the world — they figured out how to get people to take the cards, run up balances and ignore the long-term implications.

At the time, changes in the rules around credit cards were viewed as having many positive consequences. Entire populations, like students and housewives, got access to spending power and the chance to build an independent credit record. Credit cards changed the allocation of credit from whatever the local bank manager thought about you to a more objective formula, which was based on things like your ability to pay and not the color of your skin or social status. And if you were truly facing an emergency, credit card debt could get you through a rough patch. But whoa, hasn’t bankings’ dependence on cards now gone way too far?

Retroactive changes to interest rates on existing balances, increasing interest rates for payment issues with other lenders (such as the phone company), selling an account from one provider to another and charging customers for the transaction. And fees, fees, fees galore — for everything from late payments to charging above your maximum. It is just amazing. And at some level, I think this behavior violates most people’s basic understanding of what is a fair and appropriate way to treat consumers.

My prediction is that for the first time in several decades, there may be a populist, political and economic perfect storm that will result in a reining in of the card companies. Now let’s hope that the useful and advantageous aspects of the card industry don’t get thrown out along with the more egregious practices.

Photo credit: Giuseppe Leto Barone


by Steve Feldman | April 28, 2009 at 1:16 PM

Prof. McGrath: What odes it cost to obtain a credit card customer in 2008/2009? The reason for my question is that I have heard Citi Mastercard has lost more than 2 million cardholders by increasing all cards by 6% recently. This increase made it to the hearings Washington. Everyone knows the banking industrey is in trouble, but isn't this a poor choice of strategy?

by Rita Gunther McGrath | April 29, 2009 at 4:22 PM

I've seen numbers all over the place, ranging from a cost of $120 to over $300 to acquire a new credit card customer. Whether Citi's recent move makes sense or not depends on the customer segment they are giving up - if they are customers the bank didn't want to hold on to, it might be strategically very sensible. Other companies have learned that sometimes the best move they can make is to "fire" certain groups of customers. ING Direct does this with banking services - call the call center too often and it's bye bye. American Express recently offered customers whom they feared would default a payment of $300 to pay up and shut down their accounts. In either case, I think this sort of behavior simply does not bode well for the industry overall - real leadership would take a stand on some kind of consumers' bill of rights here. Absent that, it's likely to be a political solution and the results are not apt to be attractive for the card companies.

by Felix Guerrera | September 03, 2009 at 1:36 AM

You finally came to a decent conclusion in the last 51 words of the last paragraph that I advised President Obama to do long ago. If they jailed loan sharks, why would credit card companies be given the freedom to Loan Sharking the people of this nation ? You found it amazing that they found a way to raise rates without the peoples response. I found it down right Criminal. Loan Sharks do these things. they are Greedy and they don't stop unless they absolutey have to or serve time in jail. Allow me to give you a tip ! What goes around comes around and when enough of the rope is taken,then the auditors come and that is when they pay for their sins ! How many have you seen get away with crime only to maybe even years later be taken down. Just sit back and watch what and watch and see how the spider catches the fly in his web. They will not be very happy Loan Sharks

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