Will Covid and Klarna kill the credit card?
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British banks once promised that credit cards would be a “flexible friend” for shoppers. Today, even the chief executive of one of the country’s fastest-growing card issuers admits that “customers are falling out of love with it”.
Credit cards spread so quickly after being introduced in the late 1960s that it only took five years for MPs to start warning that “we are moving to what might be called a ‘cashless society’.”
Half a century later, parliamentarians are still fretting over the shift away from cash, but some doubt whether cards will have any place in the new society that emerges.
The sudden onset of the coronavirus pandemic last year caused an unprecedented hit to credit card borrowing around the world. But even before that, growth was slowing in the UK. The annual increase in credit card lending peaked at close to 10 per cent in 2018, but it had more than halved to 4.5 per cent by the start of 2020, according to Bank of England data.
The crisis has merely added to the challenges facing card issuers, who are grappling with tighter rules, a growing preference for debit cards and the rising popularity of alternative credit sources such as “buy now pay later” services.
Fintech enthusiasts such as Aman Behzad, managing partner at corporate advisory firm Royal Park Partners, believe these new rivals will cause “the slow death of credit cards”.
Senior bankers may be slightly more optimistic, but the combination of pressures is nonetheless forcing them to re-evaluate their business models in an attempt to fight back.
“I think the marketplace of credit cards and the whole nature of consumer finance is something that requires thought and could lead to several different approaches coming out,” says Nathan Bostock, chief executive of Santander UK. “I certainly don’t expect it just to remain in the status quo.”
At its best, this overhaul could leave consumers with a wider selection of payment options from start-ups and traditional banks alike, with clearer terms, lower interest rates and fewer hidden fees.
Many consumers have long viewed high credit card interest rates — currently about 27 per cent — as little short of scandalous. However, customers with weaker credit scores may find it increasingly difficult to access the best deals, while regulators are concerned that some start-ups may be as guilty of reckless lending and over-aggressive advertising as some of their predecessors.
Credit cards under Covid
The UK has one of the highest rates of credit card adoption in the world, with more than 52m open accounts — though the figure fell by 3m in the 12 months to May, according to UK Finance.
Outstanding credit card balances dropped by more than £14bn between the start of the pandemic in February 2020 and June of this year, to £41bn, as consumers stuck at home had less opportunity to spend and many chose to pay down existing debts.
In contrast, debit card usage — whether physical cards or through digital services such as Apple Pay that are connected to a card — has continued to grow despite temporary drops during lockdowns. Debit card spending in May this year was up 18 per cent year on year and 9 per cent higher than the same month in 2019, according to UK Finance.
Credit card spending has picked up as the economy has reopened in recent months, but balances have not risen at the same rate, as more customers pay off their debts in full each month.
That trend is expected to tail off as customers use up savings that were put aside last year and resume big-ticket purchases, but some executives believe the experience of life under lockdown may have caused a permanent shift in behaviour.
“Those saving habits, are they going to stick once we come through the pandemic fully? I’m seeing signs that they are, with more people saving who have never done so in the past,” says the chief executive of one large bank, though cautioning that this may change when holiday travel resumes fully.
A recent report by Barclays estimated that, even under its most optimistic “bull case” assumptions, credit card balances in the UK would not get back to 2019 levels before the end of 2023.
Aman Rakkar, a Barclays analyst, says: “It typically takes a long time for credit card balances to build unless industry risk appetite increases and people start suddenly wanting to borrow.”
The sudden drop in spending caused by lockdowns has also disguised the impact of some longer-term trends. New rules require banks to start helping customers who are in “persistent debt” to pay down their balances.
That threatens one of their main sources of income. Banks earn a small amount of money through transaction fees whenever a customer uses their card, but most fees go to companies such as Mastercard and Visa that provide the infrastructure that powers cards issued by banks. For the lenders, the bulk of their income comes from those who pay lots of interest.
The new rules will help vulnerable borrowers, but will also make banks reluctant to lend to them again, or to similar customers whom they now expect will be less profitable in future. The Financial Conduct Authority has already had to intervene after finding that some banks were considering introducing blanket bans on customers in persistent debt.
While growth in traditional credit card lending slows, alternatives such as “buy now pay later” have boomed. BNPL usually allows customers to split a purchase into between three and seven interest-free instalments over several months, or to pay for smaller purchases within 30 days.
These basic loans are little different to traditional point-of-sale financing offered everywhere from sofa retailers to electronics stores, but the ease of use and addition of Gen Z-friendly branding has made them popular with customers and retailers.
Britons spent at least £2.7bn through BNPL in 2020, according to the FCA. That is still only a fraction of the total credit market, but was almost four times higher than in 2019.
It is also expanding beyond its roots on youth-focused online shopping sites like Asos and Boohoo. Klarna says its fastest-growing user base is 40- to 54-year-olds, and several companies are looking to offer credit products in physical stores too.
Philip Belamant is chief executive of Zilch, which offers a “virtual card” that allows customers to use its BNPL service in any store that accepts mobile payments such as Apple Pay — rather than being tied to specific shops.
Belamant says: “Will BNPL kill the credit card? That would be naive to assume, but we do have huge growth ahead, absolutely . . . and I think you will see a downward trend [in credit card usage].”
A recent fundraising by Klarna symbolised the potential changing of the guard. The deal valued Klarna — whose chief executive has described banks and other credit card lenders as “extortion schemes” — at $45.6bn, just ahead of the market value of Barclays, the bank that brought credit cards to Britain.
The growth potential has caught the attention of regulators. An FCA study published this year found that BNPL can be a cheap, useful alternative to other forms of credit, particularly for people with weak or limited credit records who may not be approved for a long-term revolving credit line.
However, it also warned that many customers were unsure whether BNPL was credit, assumed that it came with the protections of a regulated service, and found it difficult to keep track of their debts across multiple providers.
Most BNPL companies neither carry out full credit checks before lending nor report their loans to credit reference agencies. That means other lenders cannot determine if a customer already has multiple loans from another provider. This makes it easier for a reckless borrower to take out more loans and prevents lenders from accurately check affordability.
Alex Marsh, head of Klarna UK, says that BNPL can be more “dynamic” than other types of lending by testing eligibility before each purchase, instead of carrying out a single credit check when you apply for a credit card. He acknowledged, however, that the lack of information sharing between different lenders needs to be addressed.
“When we launched this, there weren’t any other parallel products, so we were able to have full information [about customers]”, he says. “There are now many new entrants, and there is an industry challenge that needs to be overcome to make sure there is visibility over these products for all providers to make the best decisions.”
The interest-free credit at the heart of BNPL could also come with a catch. The majority of BNPL providers’ revenue comes from charging retailers a fee on each transaction. That means, in the words of the FCA, “the real target customers of BNPL providers are not the borrowers, but the retailers with which they partner”.
That could lead to conflicts of interest if a retailer, for example, pressured a BNPL company to approve more lending to encourage more sales. Firms that refuse risk losing their contract to a more compliant rival.
“What might happen is firms end up overlending to you or I at the checkout because they’re being told to increase acceptance rates by the retailer,” says Zilch’s Belamant. Zilch says it avoids the issue by not being tied to specific stores, and has full FCA authorisation.
Klarna’s Marsh counters that “we have no incentive to offer this product to customers who will not repay us . . . If we have one customer who doesn’t pay us because we haven’t assessed eligibility right, that [cancels out] the income from many purchases.”
Banks fight back
The government has said it will give the FCA powers to regulate BNPL, but it is not expected even to begin consulting on new rules until next year. Regulation cannot come quickly enough for some bankers, who complain that they are losing out due to an uneven playing field.
“If I think of the amount of pressure I’m under as a deposit taker and the care and attention I have to take when providing unsecured lending to younger people, it is staggering me that Klarna et al are allowed to do what they’re doing,” says the chief executive of another high street bank.
In December, the Advertising Standards Authority banned several Klarna advertisements that “irresponsibly encouraged the use of credit to improve people’s mood”, and published new guidelines to make sure all providers make clear that BNPL is a type of debt.
Still, customers with long memories may be unsympathetic to the bank chief’s claim to be “deeply uncomfortable” with BNPL practices considering the number of mis-selling scandals that banks themselves have been caught up in. Consumer watchdogs have also long complained about the high interest rates banks charge on credit cards, which typically account for just 5 to 10 per cent of banks’ total lending but between 13 and 31 per cent of revenues, according to Barclays.
Despite criticising BNPL providers’ methods, the executive admits: “Young consumers have sent a strong message that that’s the type of solution they want . . . We need to find a way of doing it with the types of checks and balances we would do if approving new personal lending in a bank.”
Some banks are waiting to see how the FCA decides to regulate BNPL services before coming up with their own version, but others are already trying to make changes.
NatWest and HSBC have started allowing existing cardholders to create structured instalment plans for individual purchases, similar to using BNPL. There are still some fees, though they are lower than their standard credit card rates. Start-ups such as Monzo this week announced a new service that combines elements of credit cards and BNPL, which includes a pre-approved credit limit like a traditional card but with separate instalment plans for individual items and no interest for purchases that are paid off in two months. Fellow start-up Revolut has also said it is developing a BNPL-like product, though is yet to provide full details.
Zopa, which started as a peer-to-peer lender but now operates with a full banking licence, plans to introduce a similar feature on its credit cards next year. Jaidev Janardana, Zopa chief executive, says the growth of services such as BNPL is proof that the cards industry “lost its way” through its focus on confusing interest rates, unexpected fees and drawing customers in with long interest-free periods in the hope that they would fail to pay down their balances in time.
“The product went from meeting a consumer need to something incredibly complicated. Customers were scared of it almost.”
Some habits are unlikely to change. Zero per cent balance transfer offers are popular with older customers convinced they will be among the minority who avoid being hit with charges when the offer runs out. Banks such as Virgin Money, Sainsbury’s Bank and Barclaycard have ramped up their offerings in recent months as they look to rebuild balances lost during the pandemic.
Still, Janardana says Zopa has proven since the launch of its cards last year that even young people can be attracted if they are offered straightforward interest rates and features such as spending and balance updates that help them manage their debts.
Zopa recently started using new technology to check the creditworthiness of people who might be good at managing their money but who have thin files with traditional credit reference agencies, such as those who have only ever borrowed through BNPL.
“The plastic is going to go away some time,” Janardana says. “The combination of online shopping combined with your phone should be able to do everything . . . but the idea of a revolving line of credit will remain . . . That need has definitely not gone.”