In Wake of CARD Act, Now Is the Time to Rethink Credit Card Pricing

There is no doubt that the Credit CARD Act of 2009 has changed the payments landscape in a major way for all issuers both large and small. Despite these challenges, credit unions are in an enviable position to thrive in the new environment with their member-friendly credit card products. In fact, it is the big issuers who stand to lose the most with their reliance on many of the practices now outlawed in the legislation. But, this does not mean that credit unions can assume they are immune to these changes. One area of current concern is whether credit unions can continue to use fixed-rate pricing strategies or whether they would benefit from a move to variable-rate cards. The regulatory changes, specifying how payments must be handled and how rate changes can be implemented, will require that credit unions remain vigilant about the effect of external influences on their card programs. Specifically, credit unions must pay careful attention to increases in their cost of funds, recognize their inability to reprice existing card balances on fixed-rate cards and deal with declining average yields across their portfolios. The issue today is how credit unions can best maintain ongoing interest yields in an environment where there are or may be significant changes in the cost of funds. Today’s environment hasn’t been seen in more than a generation. In this decade, the prime rate has ranged between 3.25% and 9.50% and has been at 6% rate for more than half of those months. You have to go back to the 1960s to see this type of prime rate activity. It is in stark contrast to the 1980s, when the average prime rate was 12%. Because of this type of rate fluctuation, it is important that credit unions take the long view when they forecast their future cost of funds. Other factors that could affect those forecasts are expectations of future economic conditions and potential inflationary pressures resulting from governmental actions. While these factors may be individually unpredictable, we do know that historically the Federal Reserve has used the fed funds rate to control inflation through increasing interest rates and slowing growth of the money supply. With the significant amount of federal stimulus money now in play, this increase in money supply could create inflationary pressures. If so, likely Federal Reserve actions to control inflation would have an adverse impact on the cost of funds. To determine an acceptable net interest margin on an ongoing basis, credit unions must assess what impact they would see from a period of higher prime rates that raises their cost of funds and determine how protected they are from any negative effects. Variable-rate credit cards allow credit unions to offer a product that adjusts interest rates based on a public index such as the prime rate, thus moving more or less in tandem with changes in the cost of funds. This offers some protection against rising interest rates and also maintains market competitiveness when rates are decreasing especially when used with a “floor” rate. This is one of the key reasons that two-thirds of credit cards carry a variable rate today. Fixed-rate cards offer no protection to credit unions in an inflationary environment, especially under the new regulation. A fixed-rate strategy requires appropriate pricing from the start-from product rollout or account setup-since there will be little opportunity to increase rates after the CARD Act goes into affect in February 2010. This poses a challenge since fixed-rate cards are a traditional staple of credit unions and often marketed as a differentiator from the big issuers. On balance, in today’s regulatory environment, the variable APR pricing model-using an index that reflects a credit union’s cost of funds-is best able to protect card program profitability regardless of economic cycle. By carefully managing variable APR pricing, changes can be made quickly and effectively in response to market conditions. There is specific disclosure language required with this approach, but once in place, it streamlines rate management. If a credit union chooses a fixed-rate strategy, however, it would be wise to assume a higher cost of funds at the point of establishing the rate structure, in order to provide a buffer in the margin to allow for potential interest rate increases. This will require a much more careful modeling of the funding risk than has ever been necessary before.