Credit card issuers, like many other financial-services companies, have greeted the Internet revolution not only with a profound sense of opportunity but also with a vague feeling of dread. For they know that their traditional business model—in which they earn 65 percent of their revenues, net of the cost of funds, from cardholders paying high interest rates—will probably come under severe pressure from on-line competitors.¹ The on-line entrants do enjoy certain advantages over incumbents: they often use state-of-the-art technology, historically have lured employees with stock options, and can afford to spend large sums of money acquiring customers without worrying about how that could affect this quarter’s earnings. Yet incumbents too have strengths, arising mainly from their dominant brands and large scales. If they move quickly, the ultimate winners might emerge from either camp or from both.

Curse or blessing?

To be sure, the incumbents’ fears are founded in reality. Consumer financial services are, for many people, commodities; one survey, carried out by McKinsey in 1999, found that 73 percent of the people who thought about applying for credit cards on the World Wide Web did so in hopes of securing a lower financing rate. Clever pricing strategies, such as the increased late fees that some issuers have tried, will thus delay only briefly the inevitable: an on-line environment of virtually transparent comparisons across credit products. Already, comparison sites such as LendingTree.com and GetSmart.com display credit products side by side so that customers can compare them on an apples-to-apples basis. Although only 9 percent of the people who have so far applied for credit cards on-line have used these sites, 44 percent of those considering the idea of applying on the Web said they would use one. Many issuers are starting to compete aggressively on interest rates.

Consumer commerce on the Web may help issuers that survive in the tougher environment of the future to divide a greatly enlarged pie

Yet issuers that survive in this tougher environment may find themselves sharing a greatly enlarged pie. Consumer commerce on the Web, according to Forrester Research, will be worth $39 billion this year—a figure likely to rise to $101 billion by 2002 and to $184 billion by 2004. Since credit cards are used to settle 85 to 90 percent of all on-line purchases (compared with 18 percent of retail purchases in the off-line world), overall credit card billings are likely to grow substantially.

In addition, credit card "extensions" could open up whole new areas of business for issuers. The possibilities include prepaid (or stored-value) accounts of the kind sold by RocketCash, accounts that can aggregate many small transactions (or "micropayments") into a bill large enough to put on a credit card, and mechanisms for making consumer-to-consumer payments electronically. Traditional issuers already have some of the technologies and customer relationships they need to make these models work, and those technologies will give them an edge as such payment methods become standard.

Even the technology of the plastic card itself is being enhanced. Last fall, American Express launched its Blue Card, a "smart card" containing a sili-con chip that stores personal information. To give just a few examples, this technology could soon make it possible for cardholders to gain instant access to their own medical records, to redeem frequent-flyer points automatically, and to receive personalized service based on their previous spending behavior.

In any case, whether issuers see the Internet as a curse or a blessing (and it is both), they have no choice but to establish a serious on-line presence quickly and decisively. More and more of their customers and competitors are going on-line; if they don’t start registering and servicing accounts on the Web, they will only guarantee their own obsolescence. So far, about 28 percent of US Web users—some 19 million people—have browsed for credit cards on-line, and in 1999 almost two million of them (representing 2 to 4 percent of the year’s total number of new credit cards) opened accounts. By 2002, the number of accounts opened on-line is likely to stand at 8 million to 12 million, or 11 to 16 percent of the total.²

Already, many traditional issuers, including American Express, First USA, and Citigroup, have an active Internet presence reinforced by extensive advertising in both new and traditional communications media. New Web issuers such as NextCard have grabbed attention by offering immediate card approval, instant balance transfers (facilitating debt consolidation), and even the option of decorating a credit card with a picture of the customer’s choice.

Surviving on-line

Even now, it should be painfully clear that there will be only two ways of surviving in this radically rationalized environment. Issuers will have to provide the cheapest service in a particular class or avoid the race to the bottom by somehow adding value for which consumers are prepared to pay.

Cutting costs

Offering the cheapest service means operating at the lowest cost. Exploiting the rich trove of personal financial information that will be available to issuers as their businesses move on-line will be crucial here. An issuer will, for instance, be able to use the data to improve its credit analysis and to recognize problems as soon as they arise. Both of these features should eventually reduce credit losses and improve the allocation of marketing budgets. By learning to recognize the indicators of consumer risk and consumer need, issuers could begin to approach commercial nirvana: the right product, placed in the hands of the right person, at the right time, and at the highest price that person will bear.

So far, the newer players seem to be better at collecting on-line data and more willing to make continuous adjustments to pricing, service, and even business models—adjustments that are needed to derive the greatest possible advantage from the data. However, some incumbents should be perfectly capable of meeting the new challenges—indeed, we would assert, those that want to thrive will have to meet them.

As the Web matures and the on- and off-line applicant pools come to resemble each other, economies of scale that rely on the combined size of on- and off-line cardholder pools will become more important. And here it may be the large incumbents, with their vast numbers of existing off-line accounts and steady stream of new telephone and conventional mail applicants, that have an advantage.

Although the credit card business is information intensive, margins are falling to low levels in some important areas, so operational economies of scale still matter. Individual service, such as phone calls and e-mails to address customer complaints, will always be important, and it will always admit huge economies of scale, which favor the bigger players. The large incumbents can also distribute their advertising and customer acquisition costs over a larger number of new accounts. And one particular asset that is created through continual advertising, service, and other corporate activities—specifically, a well-regarded brand—can be put to greater use by the large players, again because of the sheer number of their accounts. But the incumbents that survive to enjoy these advantages will have to learn to use their data nimbly enough to compete in the on-line environment.

Another way of cutting costs is to offer on-line credit account services such as billing, responses to inquiries, and the collection of payments. Savings on paper, postage, telephone calls, and staff mean that such transactions cost on-line issuers just 10 to 20 percent as much as they cost off-line ones. Already, a quarter of the cardholders who have been on-line for more than three years conduct routine credit card servicing transactions on the Web, and it is likely that by 2002 about 27 million people (or 15 percent of cardholders) will do so (Exhibit 1). Traditional issuers that have provided remote customer service for 20 years via telephone and regular mail should have a relatively easy time moving on-line. Those corners of the personal-finance business where interaction has traditionally been conducted face-to-face might have a different experience.

There is, it should be said, a downside to on-line servicing. For one thing, each time issuers make it possible to conduct a transaction on the Web, they also make it easier for consumers to conduct it more frequently. If it takes almost no effort to check your credit card balance, why not do so every day? Even if the cost per transaction plummets, the increase in transaction volumes could more than cancel out the savings. (Some transactions, such as the checking of account balances, cost issuers very little, while others, such as on-line challenges to individual charges, are labor-intensive—so the costs of large volumes can sometimes be significant.) At present, it is hard to predict how these cost-of-service issues will develop.

Some features of on-line business actually increase the cost per transaction. Issuers have been prevented from moving some transactions entirely on-line by customer resistance or legal or regulatory barriers; credit card companies are required, for example, to send written statements to all customers unless they explicitly decline the privilege. In such cases, on-line features actually increase the cost per transaction, since they come on top of the paper service.

Similarly, acquiring accounts through the Web rather than traditional bulk mailings won’t necessarily offer great savings. Banner advertisements, e-mail, and other on-line methods were certainly the least expensive way to acquire new accounts when Web-based finance was in its infancy, but those bargain prices haven’t lasted. Web users have become more jaded, and click-through rates (the fraction of Web visitors who click on a given banner advertisement) are dropping sharply—from 3 percent in 1996 to 1 percent at present—with further falls expected (Exhibit 2). The trend is beginning to push on-line account acquisition costs close to those of off-line media. Already, many credit card issuers insist on paying for Internet advertising per applicant rather than per page view, and when they do, they pay about as much per applicant as they would in traditional media.

Adding value

But cost isn’t the only important variable, even on-line. Some issuers, fortified by the sort of fine-grained transaction data that on-line accounts produce, are likely to prosper not by slashing costs but by adding value. The Web format, for instance, permits issuers to provide a high degree of customization: cardholders can specify how they want their statements to be organized and indicate whether they wish to qualify for special offers or to hear about ancillary credit services.

Credit card issuers have a uniquely good position to offer cardholders a wealth of useful detail about their individual financial profiles

In addition, the issuers have a uniquely good position for providing cardholders with a wealth of useful detail about their financial profiles. Issuers, for example, could tell customers how their spending on all sorts of items compared with that of households in their neighborhood and how much it varied by season, much as local utilities do with electricity spending. Retailers such as Amazon.com have shown how to add value to services in this way—for instance, by providing book purchasers with information about books that people with similar profiles are reading.

So far, however, few credit card issuers have done anything along these lines. NextCard probably comes closest with its monthly listing of the 25 on-line merchants that have attracted the greatest number of cardholder transactions. In the future, issuers might offer customers a list of the "top 25 places where cardholders like you bought on-line."

Issuers can also unlock value by delivering groups of prescreened, like-minded cardholders to merchants: for instance, merchants could pay on-line issuers to direct banner advertisements only to customers whose past behavior identified them as likely buyers. Alternatively, issuers could direct coupons to customers with particular profiles.

Going a step further, issuers could equip cardholders with personal shopping software that would inform them of special deals on certain products as they shopped for items in that category; essentially, the cardholder’s own shopping behavior would do the prescreening. And security and privacy concerns create opportunities for issuers to differentiate themselves by offering customers the most secure, best-insured, or most conveniently encrypted transactions on the market.

The transition to fully on-line consumer finance will bring all sorts of new challenges. Although on-line credit card applicants spend 51 percent more on their accounts and carry forward balances that are 67 percent higher than average, they are also, astonishingly, 146 percent more likely to default on their loans. Who could have predicted this?

As the on- and off-line populations converge, so too, presumably, will on- and off-line credit-scoring criteria. But that development could be three to five years into the future, and in the meantime issuers must find a way to court on-line applicants while simultaneously accounting for their default-prone—and constantly changing—risk profile. (Issuers seem to be on the right track, however: approval rates are only half as high on- as off-line.)

Puzzles like this will probably crop up in a hundred places as the credit card industry makes the transition to a new paradigm. The ability to solve such problems and to make adjustments quickly will be crucial in deciding which issuers survive long enough to enjoy the lucrative next phase of this industry.