RETAILINGRetailing in Financial Markets

• Payment Cards: Provide means to use "money" to complete a transaction between merchant and consumer

• Debit Cards

• Credit Cards

Industry Overview

Overview of the Credit Card Market in Hong Kong

• Widely used financing tool- 17 million credit cards issued in Hong Kong- On average, 3 credit cards for each adult

Cash Checks

Bulky to carry around Inconvenient to carry

Limited Purchases with fixed cash

Not easily accepted by all merchants

Easy to steal

Hard to trace

Why Choose Payment Cards?

• Provides consumer funds to purchase goods and/or services in return for payment at a later date

• Revolving Credit: Can delay repaying balance in full by paying a minimum monthly payment

• Lending Institution vs. Payment Systems• Financial institution actually lend the credit• (i.e. Visa USA Inc., MasterCard International Inc., Kohlberg Kravis

Roberts & Co., American Express Co.) provide payment systems to facilitate transactions

Credit Cards Defined

Advantages/Disadvantages to Consumer

Advantages DisadvantagesPurchase Power and Ease of Purchase

Blowing Your Budget

Protection of Purchases High Interest Rates and Increased Debts

Building a Credit Line Fraud

Emergency Spending

Rewards Programs

• 40% Cardholder Fee• Includes annual fees, cancellation fees, late payment fees, non-

usage charges, and risk-based fees

• 40% Interchange Fees• Fees charged by a bank to process transactions made on a card

from another bank.

• 20% Interest Payments• Interest on outstanding debt• Convenience Users: 55% of consumers pay their balance in full

month; called convenience users.

Revenue Model

Revenue Model (Interchange fee)

Overview of the Credit Card Market

• High Risk market- Not secured by assets

Traditional loans Credit card

Type of loans Credit Card Real Estate Commercial Personal

Delinquency rate(%) 4.33 2.1 3.06 3.27

Overview of the Credit Card Market

• Customer segmentation

Deadbeats (40%)

Rollover (60%)

Annual fee

Merchant fee/Interchange fee

Finance charge(70% of revenue)

Bad debts (charge off)

Profit for a card company is maximized when the rollover rate is as high and the charge off rate is as low

Managers’ Issues

• Card Issuers want to- Encourage profitable customers to use more - Minimize the risk of charge-off

• Research Issue : Identify consumer risk type - Screening in the application stage

(application data)- Adjustment over time (usage data)

Who are the Most Profitable Customers for the Credit Card Market?• Customers who always clear the balance before the due

date?• Customers who are always carrying debts?• The low risk type who are not clearing the balance yet

have the ability to repay all the debt eventually.

How to Identify the Profitable Customers? The Model

• Dependent variables: two decisions

1. Delinquent or not ?- A decision of whether to meet the minimum payment requirement or not.

2. Repayment amount - The amount to repay (conditional on nondelinquency)

No Yes

Pay?

How much?Delinquent

How to Identify the Profitable Customers? The Model

• Customer who is delinquent is often considered as bad credit risk by the card issuer.

• However, consumers have different reasons for delinquency

What are the reasons for consumers to be delinquent?

-high risk, lack of financial ability

-forget to repay

.

.

.

How to Identify the Profitable Customers? The Model

• Observation Equation 1

- Delinquency Equation.

*1it 1it 1it 1ity x

*1it

1it *1it

1 if y 0y

0 if y 0

How to Identify the Profitable Customers? The Model

• Observation Equation 2 - Conditional Repayment Equation

2it 2it 2it 1it2it

1it

x , if y 0y

Not Observed, if y 1

How to Identify the Profitable Customers? The Model

• Variables to include in the model• Demographics: Cardholder’s Income, Years of

employment, Educational level, and Residential status

• Card Terms: Card age (in months), Interest rate, Credit limit

Data

• Sample of cardholders from a bank- Time span: Jan. 2000 – Aug. 2002 (all

accounts opened on or after Jan. 2000)- 1500 accounts- Information Contents

1. Application data: Demographics

2. Monthly history from inception

Data

• 27% of customers always clear the balance• 17% of customers never clear the balance

0

0.05

0.1

0.15

0.2

0.25

0.3

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.95 1

Deadbeat

Rollover

Proportion of Customers

Rollover Propensity

What can managers do to increase profitability?

Card issuer can take one of the following strategies when facing a short term delinquent customer• Uniform Blocking strategy• Uniform Non-blocking strategy• Targeting strategy: predict risk type and take a customized action

Two Types of Errors of the Managers

• Type I error: misclassifying a long term delinquent customer into a low risk customer

• Type II error: misclassifying a good customer into a high risk customer

Results of the Policy Simulation

Note: p is the low risk consumer’s probability of choosing to stay with

the company even when her account is blocked.

• Use the model results to classify customers

　 Non-Blocking Targeting Strategy at Different Cut off Points (y2) Blocking Perfect

　 Strategy 0.1 0.2 0.3 0.6 0.8 Strategy Foresight

P=0.95 914 993 1023 1033 1063 1051 1041 1151

P=0.9 914 960 974 976 989 965 938 1151

P=0.85 914 932 925 920 915 880 835 1151

P=0.8 914 906 876 860 841 795 732 1151

P=0.5 914 791 583 516 396 285 112 1151

Take away

• Financial service is a business involves with high risk

• It is important to identify customer’s risk type.• Combining the delinquency and payment ratio decisions together helps to identify the profitable customers for the bank.