Competitive Effects of Basel II on U.S. Bank Credit Card Lending

Competitive Effects of Basel II on U.S. Bank Credit Card Lending





William W. Lang
Federal Reserve Bank of Philadelphia


Loretta J. Mester
Federal Reserve Bank of Philadelphia and
The Wharton School, University of Pennsylvania


Todd A. Vermilyea
Federal Reserve Bank of Philadelphia




May 11, 2006
















Correspondence to Lang at Supervision, Regulation, and Credit Department, Federal Reserve Bank of
Philadelphia, Ten Independence Mall, Philadelphia, PA 19106-1574; phone: (215) 574-7225; e-mail:
William.Lang@phil.frb.org. To Mester at Research Department, Federal Reserve Bank of Philadelphia,
Ten Independence Mall, Philadelphia, PA 19106-1574; phone: (215) 574-3807; e-mail:
Loretta.Mester@phil.frb.org. To Vermilyea at Supervision, Regulation, and Credit Department, Federal
Reserve Bank of Philadelphia, Ten Independence Mall, Philadelphia, PA 19106-1574; phone: (215) 574-
4125; e-mail: Todd.Vermilyea@phil.frb.org.

We thank Jim DiSalvo and Vidya Nayak for research assistance and Sally Burke for editorial assistance.

The views expressed in this paper do not necessarily represent those of the Federal Reserve Bank of
Philadelphia or the Federal Reserve System.

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Competitive Effects of Basel II on U.S. Bank Credit Card Lending


William W. Lang
Federal Reserve Bank of Philadelphia


Loretta J. Mester
Federal Reserve Bank of Philadelphia and
The Wharton School, University of Pennsylvania


Todd A. Vermilyea
Federal Reserve Bank of Philadelphia


Abstract


We analyze the potential competitive effects of the proposed Basel II capital regulations on U.S.
bank credit card lending. We find that Basel II is not likely to have a competitive effect on community
banks and most regional banks. Bank issuers that operate under Basel II will face higher regulatory
capital minimums than Basel I banks. During periods of normal economic conditions, this is not likely to
have a competitive effect; however, during periods of substantial stress in credit card portfolios, Basel II
banks could face a significant competitive disadvantage relative to Basel I banks and nonbank issuers.



JEL classification: G210, G280, D430
Keywords: Basel Accord, Basel II, capital requirements, bank regulation, competition

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Competitive Effects of Basel II on U.S. Bank Credit Card Lending


1. Introduction
This paper analyzes the potential competitive effects of the proposed Basel II capital regulations
on U.S. bank credit card lending. Under Basel II, a small number of large U.S. banking organizations
would be classified as “mandatory banks.” These banks would be required to use the advanced internal
ratings-based (A-IRB) approach for credit risk and the advanced measurement approach (AMA) for
operational risk. It is expected that a relatively small number of mostly large U.S. banks are likely to
“opt-in” to Basel II and use the A-IRB and AMA. However, the vast majority of other U.S. banks would
continue to operate under the current Basel I capital rules.1 While the current regulatory capital
framework requires the same minimum capital charge for all credit card exposures regardless of credit
quality, the Basel II framework would be more risk sensitive with minimum capital requirements based
on banks’ internal estimates of the probability of default (PD), loss given default (LGD), and exposure at
default (EAD).
The Basel II proposal raises questions about the competitive positions of banks adopting Basel II
relative to banks remaining under the current capital regime and relative to nonbank rivals. Some
bankers, particularly community bankers, have expressed concern that Basel II banks would face lower
capital requirements for various products (including credit cards) and thus give Basel II banks a
competitive advantage.2
Basel II will generate competitive effects only if the regulatory capital constraint is binding (i.e.,
for a given portfolio, minimum regulatory capital requirements cause banks to hold more capital than they
would hold in the absence of the requirement). A central component of our analysis will be to determine

1 This paper considers the Basel II regulations as stated in the June 2004 Basel Committee Framework Agreement.
The U.S. banking agencies have proposed modifications to the current capital standards that would increase the risk
sensitivity of those standards. For the purposes of this paper, we assume that banks not adopting Basel II will
operate under the current Basel I rules, and we will use the term “Basel II bank” as a bank operating under the
A-IRB rules of Basel II, and “Basel I bank” as a bank not operating under A-IRB.
2 See “Smaller U.S. Banks Say Basel Accord Unfair,” Reuters News, June 22, 2004. This study uses the term
“community bank” for banking organizations with assets of less than $1 billion. We use “regional bank” to refer to
banking organizations with assets over $1 billion that operate in regions of the U.S. and not nationally or globally.
Unless otherwise noted, the term “bank” will mean depository institution more generally.

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whether regulatory capital requirements for credit card portfolios are currently binding or are expected to
be binding under the proposed Basel II regime.
Three caveats to the analysis presented in our paper are noteworthy. First, the analysis is based
on the current Basel II proposal, which has not yet been written into U.S. rules and is subject to revision
as well as to changes in interpretation. Second, the analysis is based on the current Basel I rules, which
may be modified before the effective date of Basel II. Third, our analysis focuses solely on the domestic
U.S. credit card market. We do not consider the potential competitive effects on international credit card
operations.
The remainder of the paper is organized as follows: Section 2 provides descriptive background on
the most important features of the credit card industry. Section 3 describes the current and proposed
regulatory capital framework. Section 4 lays out our analytical framework for assessing changes in
regulatory capital standards. Section 5 analyzes whether regulatory capital requirements are currently
binding or are expected to be binding under Basel II. Section 6 concludes and presents several likely
reactions to the Basel II A-IRB framework that banks could have in response to the bifurcated capital
regime.
2. Description of the credit card market

Credit cards are an extremely important asset class to the commercial banking system. As of
June 30, 2004, summing across all commercial banks, managed credit card outstandings totaled $623
billon.3 In addition, there was $3,085 billion in unused credit card lines in the commercial banking
system. Charge-offs on credit cards totaled $3,312 million or approximately half of all charge-offs in the
commercial banking system on a year-to-date basis.

3 Managed outstandings are defined as the sum of on-balance-sheet credit card loans, outstanding credit card
receivables sold and securitized with servicing retained or with recourse or other seller-provided credit
enhancements, and seller’s interest in credit card securitizations held on balance sheet as securities. About half of
credit card receivables are “on balance sheet” in the form of credit card loans, while about half are “off balance
sheet.” The figures are based on Call Report data as of June 30, 2004 for commercial banks. All figures in this
paper are based on this source unless otherwise noted.

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2.1. Market concentration

Although 1,982 commercial banks issued credit cards as of June 30, 2004, the top 10 issuing
banking organizations (at the top holder level) manage approximately 93 percent of the $623 billion in
commercial bank-managed credit card loans outstanding, while the top 20 issuers manage approximately
98 percent. 4 This is a higher level of concentration than for commercial banking overall, where the 10
largest banks in the U.S. held less than half of the U.S. banking industry’s assets in 2004. Moreover,
concentration of credit card lending is increasing. In 1990, the top 10 issuers held only 55 percent of the
commercial bank credit card market; by 1998, this figure had grown to 76 percent.5 More recently,
Citigroup’s purchase of the Sears portfolio, Bank of America’s merger with Fleet, JP Morgan Chase’s
merger with Bank One, and Bank of America’s purchase of MBNA have increased concentration in the
credit card industry. Once these transactions are accounted for, the top 10 issuing banks will control
nearly 95 percent of credit card loans managed by commercial banks.
2.2. Credit card specialty banks: independent and affiliated monolines

As of June 2004, there were 23 independent “monoline” credit card banks.6 While some
independent monoline banks (e.g., Capital One) are among the largest credit card issuers, most members
of this group are small banks that concentrate almost all of their lending in credit cards (e.g., First
National Bank of Marin, Direct Merchants Credit Card Bank, NA). Independent monoline banks account
for 42 percent of credit card loans managed within the commercial banking industry.7
In addition to the 23 independent monoline banks, large diversified banking organizations
typically place their credit card operations in a separate subsidiary with a separate bank charter.

4 There is no precise estimate of the amount of credit card lending outside of the banking system. Based on the
Board of Governors of the Federal Reserve System G19 report, as of June 2004, outstanding revolving consumer
credit held at banks and nonbanks equaled $773 billion. However, while the bulk of the revolving consumer credit
number reported in the G19 report represents credit card debt, other types of debt are included. Nevertheless, we can
say from the G19 report and the Call Report data that credit card debt managed by commercial banks represents over
80 percent of the credit card market.
5 Historical data on market shares are based on the Nilson Report from various years.
6 We define a monoline as a bank for which credit cards account for 50 percent or more of its managed loan
portfolio. Independent monoline banks are institutions for which this definition holds at the highest holder level.
7 This share has dropped substantially since 2004 mainly due to Bank of America’s acquisition of MBNA, which
was the largest independent monoline credit card bank.

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Currently, 15 monoline banks that specialize in credit card lending are affiliated with diversified banking
organizations (e.g., Citibank South Dakota, Bank of America USA, and BB&T Bankcard Corp). We
refer to both the affiliated and independent monoline credit card banks as credit card specialty banks
(CCSBs). CCSBs account for 84 percent of all managed credit card loans in the commercial banking
system.
2.3. Community and regional banks
Community banks and most regional banks have largely exited the credit card market (BB&T and
First National Bank of Omaha are notable exceptions among regional banks). Banks with assets under $1
billion, excluding independent monolines, account for 0.20 percent of managed credit card loans in the
commercial banking industry, and most banks have no credit card loans. Of those community banks that
have any credit card loans, the median bank in terms of credit card loans managed does not securitize
credit card loans, and credit card loans are less than 0.36 percent of the median bank’s total loan portfolio,
suggesting there are important scale economies in the industry. Likewise, credit cards play a small role
for most regional banks. Non-CCSB banks with assets over $1 billion but not meeting the criteria for a
mandatory Basel II bank account for only 1.6 percent of all credit card loans managed by the commercial
banking industry.
2.4. Nonbank issuers
Nonbank companies, such as Morgan Stanley, American Express, General Electric, and (until
recently) Sears, are substantial competitors in the credit card industry. However, no major nonbank
competitor in the credit card-issuing industry operates completely outside the banking system, since they
have chosen to operate significant banking subsidiaries (e.g., Discover Bank, American Express
Centurion Bank, GE Money Bank, and Sears National Bank, respectively). Furthermore, many private-
label store and gas cards are operated within banking subsidiaries.
Two factors seem to be important in the banking industry’s dominance of this market. First, Visa
and MasterCard bylaws require firms issuing their cards to be depository institutions. Second, there
appears to be a net regulatory benefit to issuing credit cards through a depository institution. This benefit
is derived from banks’ ability to export home-state consumer protection laws on credit card products

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(particularly usury laws) to customers in other states. But while many nonbanks issue credit cards
through a bank affiliate, nonbanks can and do differ substantially from banking organizations in how
much of their credit card portfolio is held within the banking system and therefore subject to bank capital
regulations.8 For example, American Express manages approximately 47 percent of its credit card
portfolio outside of the banking system, while Morgan Stanley manages approximately 6 percent of its
credit card portfolio outside of the banking system.
Banks do not enjoy any obvious informational or maturity-transformational advantages in credit
card lending relative to nonbanks. Therefore, if the costs associated with regulatory capital requirements
and other regulatory burdens at banks are greater than the benefits, we would expect to see credit card
exposures increasingly being held by nonbanks. However, Citigroup’s recent acquisition of the Sears
credit card portfolio does not support this view, since the acquisition transferred credit card assets from a
nonbank to a banking organization.
2.5. Potential Basel II banks
Approximately 70 percent of credit card loans managed by commercial banks are currently
managed by banks that are expected to meet mandatory Basel II standards. Some major CCSBs would
not meet mandatory Basel II standards under the current proposal but could choose to “opt in” to the
Basel II approach. Smaller, independent CCSBs are expected to continue operating under current Basel I
capital guidelines.

8 When Sears was in the credit card business, Sears National Bank originated MasterCard credit cards – providing
the interest rate advantage of banking and the ability to use the MasterCard logo and system – but each night the
loan balances were transferred to the parent corporation to avoid bank regulatory burdens. At any given moment,
Sears National Bank’s credit card balances were negligible, despite the fact that Sears, Roebuck Corporation
managed a $30 billion credit card portfolio.

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2.6. Funding strategies
Much of the funding of credit card operations comes from the wholesale market (uninsured
borrowing from sophisticated lenders) rather than traditional deposits. Approximately 60 percent of all
credit card loans originated by commercial banks are funded off balance sheet in the form of the
investors’ interest in credit card asset-backed securities (CC-ABS). Credit card securitization occurs
almost exclusively among the largest issuers and some smaller monoline banks. Given the importance of
securitization in financing credit cards, a description of the mechanics of this process is essential to
understanding the industry overall and the impact of capital regulation in particular. Appendix 1 provides
details on the mechanics of CC-ABS.
3. Description of the regulatory capital regimes
Both Basel II and the current Basel I capital regimes prescribe minimum regulatory capital levels
for banks as determined by two ratios: the ratio of tier 1 capital to risk-weighted assets and the ratio of
total capital (tier 1 + tier 2) to risk-weighted assets. In general, tier 1 capital comprises funds that protect
the bank against insolvency (e.g., equity), while tier 2 capital comprises additional funds that protect the
FDIC insurance fund from losses (e.g., preferred stock, subordinated debt). Under both regimes, the
minimum regulatory standards are 4 percent and 8 percent for the tier 1 and total capital ratios,
respectively. However, the two regimes calculate risk-weighted assets and regulatory capital differently.
3.1. Current regulatory framework
3.1.1. Calculation of risk-weighted assets. To calculate risk-weighted assets it is convenient to
think of credit cards in three pieces: outstandings held on balance sheet, the differences between the
maximum credit line and the outstanding balance (e.g., the ”open to buy” or undrawn credit lines, which
are recorded as unused commitments in the Call Reports), and credit cards funded off balance sheet
through securitizations. Under current Basel I capital rules, on-balance-sheet credit card loans are
assessed a 100 percent risk-weight and, thus, a 4 percent tier 1 and an 8 percent total risk-based capital
requirement. Undrawn credit card lines are not assessed a capital charge.
The “investors’ interest” in credit card asset-backed securities (CC-ABS) is treated as a sold asset
and, therefore, has zero risk-based capital requirements. However, the “seller’s interest” in CC-ABS –

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the seller’s share of the receivables in the pool – is typically recorded on the selling bank’s balance sheet.
Thus, seller’s interest has the same risk-based capital requirements as other on-balance-sheet loans (i.e., 4
percent tier 1 capital and 8 percent total capital).
3.1.2. Calculation of capital: the treatment of expected losses, reserves, and capital deductions
related to CC-ABS. The Basel I regime measures capital held against all losses (both expected and
unexpected). Thus, the allowance for loan and lease losses (ALLL) is included as a component of tier 2
capital subject to the restriction that the ALLL included as capital not exceed 1.25 percent of a bank’s
risk-weighted assets. This reserve cap is calculated for the bank’s entire portfolio and is not calculated
separately for each asset type.
Credit card securitizations typically generate a variety of residual interests in the securitization,
including the gain-on-sale generated by the sale of credit card receivables to the special-purpose trust,
spread accounts, and cash collateral accounts. Residual interests in credit card securitizations are
effectively subject to dollar-for-dollar capital deductions, with half of the deductions coming out of tier 1
and half of the deductions coming from tier 2 capital.9 However, residual interests, if externally rated BB
or higher, would not be deducted dollar-for-dollar from risk-based capital.
3.2. The Basel II A-IRB framework
3.2.1 Calculation of risk-weighted assets. Under Basel II, banks will calculate risk weights using
the A-IRB approach. In the A-IRB approach, risk weights for on-balance-sheet credit card exposures are
a function of the probability of default (PD), loss given default (LGD), and exposure at default (EAD), all
of which the bank provides based on its own internal estimates. To calculate these estimates, a Basel II
bank must allocate its credit card portfolio into segments with homogeneous risk characteristics and then
estimate the PD, LGD, and EAD associated with each segment. These internally estimated parameters
then generate a regulatory capital requirement based on a “risk-weight” function for qualifying revolving

9 Technically, the current rules require banks to account for residual interests by augmenting their risk-weighted
assets rather than through a capital deduction. However, the method for converting residual interests into risk-
weighted assets has the same effect on effective minimum capital requirements as a deduction from the capital level.

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retail exposures (QRREs) developed by the Basel Committee. QRREs include most unsecured revolving
lines of credit (e.g., credit card and overdraft protection portfolios).10
A key regulatory factor entering the risk-weight function is the asset value correlation (AVC),
which reflects the correlation of losses among the assets within a given asset class (e.g., QRREs,
commercial and industrial loans, mortgage loans). A high AVC indicates that losses among the assets
tend to move together, so that losses during a stress period will likely be large relative to the average loss.
A low AVC indicates that losses tend not to move together, so that losses during a stress period tend to
stay closer to the average loss rate. Since regulatory capital is meant to serve as a buffer in a stress
period, a higher AVC indicates higher required capital, other things equal. The AVC for credit card
portfolios is set at 4 percent under the current proposal.11
The risk weight for QRREs, RW, is calculated according to the following formula:
??
?1
? N PD +
??
(
?1
(
)
AVC × N (0.999)) ? ?
?
RW =12.5
LGD × N ?
? ? ? (LGD× PD)?.
??
?
?
1 ? AVC
? ?
?
?
?
??
?
? ?
?
?

N( · ) and N-1( · ) represent the normal cumulative distribution function and its inverse. The value of
0.999 in the term
1
?
N ( 999
.
0
) reflects the choice of the 99.9th percentile value as the solvency standard
for the minimum regulatory capital requirement, which is consistent with a bond rating in the BBB+ to
A? range.
To calculate risk-weighted assets (RWA), the bank multiplies the risk weight (RW) by exposure
at default (EAD), that is, RWA = RW × EAD. The total minimum regulatory capital required under
Basel II, then, is K = 0.08 × RWA = 0.08 × RW × EAD, and so required capital per dollar of exposure at
default is k ? K / EAD = 0.08 × RW. 12

10 To qualify for QRRE treatment under Basel II, credit card portfolios need to demonstrate “low volatility.”
However, currently there are no concrete criteria for determining low volatility, and so, for the purposes of this
paper, we assume that all consumer credit card exposures will be considered under the QRRE risk-weight function.
11 This is small compared to the AVCs for other assets, e.g., 15 percent for residential mortgages and 12 percent or
more for large corporate loans.
12 Note that K/EAD is equal to the term in the square brackets in the RW equation. Because the regulatory capital
requirement is intended to cover unexpected losses, expected losses (= LGD × PD) are subtracted in the formula.

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Document Outline

• Competitive Effects of Basel II on U.S. Bank Credit Card Lending
• Abstract
• 1. Introduction
• 2. Description of the credit card market
  • 2.1. Market concentration
  • 2.2. Credit card specialty banks: independent and affiliated monolines
  • 2.3. Community and regional banks
  • 2.4. Nonbank issuers
  • 2.5. Potential Basel II banks
  • 2.6. Funding strategies
• 3. Description of the regulatory capital regimes
  • 3.1. Current regulatory framework
  • 3.2. The Basel II A-IRB framework
• 4. Analytical framework for assessing minimum regulatory capital standards
  • 4.1 The influence of regulatory capital minimums on bank capital: a simple model
• 5. Are regulatory capital requirements a binding constraint?
  • 5.1. Are current (Basel I) rules binding for credit card banks?
  • 5.2. Basel II capital requirements with a zero CCF for the investors? interest in securitized receivables
  • 5.3. Basel II capital requirements with a positive credit conversion factor for the investors? interest in securitized receivables
• 6. Conclusions and implications
• Figure 1. The Relationship between Regulatory Capital Standards and Actual Capital Holdings
• Figure 2. Commercial Bank Credit Card Securitization Rates and Equity Capital AssetRatios for Credit Card Specialty Banks (CCSBs)
• Table 1: Selected Financial Data for All Credit Card Specialty Banks (CCSBs), June 2004
• Table 2. Difference-in-Means Test for Noncredit Card and Credit Card Specialty Banks (CCSBs)
• Table 3a: Equity Capital Ratio Regressions
• Table 3b: Total Capital Ratio Regressions
• Table 3c: Tier 1 Capital Ratio Regressions
• Table 4: Change in Credit Card Specialty Banks? Required Capital from a Shift from Basel I Rules toBasel II A-IRB Rules
• Table 5: Hypothetical Example of Impact of Basel II Capital Requirement
• Appendix: Calculating the Change in Minimum Capital Requirements from a Shift fromBasel I to Basel II
• References

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