Spotlight on Financial Services

Do Consumers Really Want Credit Card Reform?

With new sessions of state legislatures and the U.S. Congress underway, let us anticipate some of the credit card legislation that may tempt legislators. Two types of charges on cardholders are likely to come under legislative assault at some point:

Special charges on cardholders who repay their accounts in full each month; and
"High" finance charges on unpaid balances.

We have noted in earlier issues of Spotlight that during our recent period of affluence, an increasing portion of credit cardholders were paying their accounts in full each month, thereby avoiding finance charges. In response, some banks began assessing fees on such accounts. In addition, consumer groups assailed "predatory" interest charges on high-risk cardholders. Also, recall our report in the January issue of Spotlight that the rates charged on revolving balances during November 2000 were up 46 basis points from a year earlier.

Since history tends to repeat itself, it is worthwhile to review the history of earlier legislative efforts to "protect" credit cardholders. The purpose of this review is to identify the economic arguments that ultimately succeeded in persuading most legislatures (but not all legislators) that the proposed credit card reforms would do consumers more harm than good. These issues are ably addressed in an article by Kathryn L. Combs and Stacy L. Schreft in Economic Review published by the Federal Reserve Bank of Kansas City. They begin by discussing the efforts by Congress over many years to pass legislation that would either cap interest rates on credit cards or prevent card issuers from imposing fees for on-time payments in full of credit card bills. Both rate caps and the prohibition of certain fees were simply efforts by legislators to impose price controls. In each case, the authors discuss the origins of the proposed regulations and then the economic analysis of the effects of each proposal on consumers.

Rate caps

Even if we were confident that all state legislatures and Congress would make decisions regarding credit cards based on sound economics, it is worth recalling the events surrounding the last major effort to cap credit card rates in 1991. During a fund-raising event, President George Bush strayed from his prepared text and commented that he would like to see credit card rates come down. "The next day a bill was introduced to cap credit card interest rates at four percentage points above the rates the IRS charged for the underpayment of taxes." In spite of the fact that this rule would have put the cap about five percentage points below the prevailing average rate on bank credit cards, the bill passed the full Senate by 74 to 19 on the day that it was introduced. "A week later, when the House debated the legislation, all signs pointed to its passage." However, sanity returned to the House when the stocks of banks with large portfolios of credit cards "plummeted, reportedly in response to the expected vote in favor of the measure." Congress immediately dropped the proposal.

Legislators that seek to cap interest rates on credit cards to "protect" consumers might ponder the advice of Nobel Laureate economist Milton Friedman. He observed, "I know of no economist of any standing . . . who has favored a legal limit on the rate of interest that borrowers could pay or lenders receive-though there may have been some." (Milton Friedman, "Defense of Usury," Newsweek, April 6, 1970) A rate ceiling on credit cards is especially mischievous because there are so many adjustments that banks might make, each of which harms some group of consumers.

If the rate cap is especially low, some lenders may react by canceling the credit cards of high-risk and high-cost consumers. These would be consumers with poor credit records, frequent delinquencies, and "thin" credit files, as well as those who use the card infrequently or who carry small balances. But, there are other possible reactions, each of which harms an identifiable group of consumers. Card issuers might increase late payment fees and annual fees for the card. Or, some banks might reduce the quality of customer service-long waits to answer customers' phone calls, for example. Others might drop rental-car insurance, lost-luggage insurance, and other benefits. Finally, and quite likely, banks could raise the interchange fees assessed merchants who accept their credit cards. In turn, merchants will probably offset the higher interchange fees by raising their cash prices. The higher prices are especially harmful to those consumers who do not have bank credit cards and who, therefore, do not benefit from the cap on interest rates.

These economic predictions were fulfilled in early 1980, when interest rates rose sharply. In many states, the interest rates on credit cards were subjected to state usury laws. A congressional survey of 96 separate card offerings by 59 institutions found that annual fees were imposed on 49 percent of the cards. Further, new applications were not accepted on 42 percent of the cards, and credit standards were raised on 41 percent of the cards. Other responses were to calculate the finance charge differently (less favorable to the consumer) and to increase the size of the minimum monthly payment.

Caps on fees

In September 1996, GE Capital Corporation announced that it would impose a $25 annual fee on holders of its GE Rewards cards that paid less than $25 in interest charges annually. In response, Representative Joseph Kennedy introduced a bill in 1997 that would cap annual fees at $0. His bill also would have prohibited retroactive interest charges on required payments not made during the grace period. In early 1999, Congressman John LaFalce introduced a bill that would have prohibited charging higher fees, interest rates or canceling accounts of consumers who paid their accounts in full. Other bills with similar terms crowded the "in file."

Fortunately, the efforts to cap "user fees" have made little progress. Their imposition would set off the same set of evasions that have accompanied the imposition of rate caps. If a rate cap prevents raising rates to offset the cap on fees, card-issuing banks can turn to all of the other response options cited earlier. In summary, if state or federal legislators seek to limit the various prices of credit cards, they will harm consumers even as they create the appearance of helping a particular subset of card users.

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