RETAILING
Retailing 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 Disadvantages
Purchase 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 0
y
0 if y 0
 
 


How to Identify the Profitable Customers?
The Model
• Observation Equation 2
- Conditional Repayment Equation
2it 2it 2it 1it
2it
1it
x , if y 0
y
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.