How Valuable is Credit Card Lending?

Abstract

Standard methodology for valuing interest-dependent assets is by now well established, with the Heath-Jarrow-Morton (HJM) model being one of the most widely-used approaches. However, despite representing a significant portion of many banks' portfolios, credit card loans as an asset class have not been brought into the standard valuation framework. Like a bond position, valuing a bank's credit card loan portfolio involves projecting the levels of future interest rates. But a portfolio of credit card loans also has several special features not shared by bonds. One is that the total loan face value shows long-run growth, but also short-term fluctuation, reflecting both seasonal effects and interest rate changes. A second is that the profitability, and hence the capitalized value, of the loan portfolio depends on the difference between the rate earned on the loans and the rate the bank must pay to fund those loans, so both rates need to be modeled. In this article, Chatterjea, Jarrow, Neal, and Yildirim offer a general modeling approach for valuing a bank's credit card loan portfolio within an extended HJM paradigm, and then illustrate how it works by fitting it to the credit card portfolios of five different banks.