Credit card interest rate caps do not make sense.

According to medieval Christian ethical standards, charging interest per se was considered fundamentally immoral, but over a period of time, this attitude underwent a change and charging interest became acceptable as long as the rate was reasonable [Stuhldreher and Ulrich 1989]. The US Supreme Court in Munn vs. Illinois (1896) ruled in favor of the right of states to set ceilings on interest rates. Subsequently, many states passed what are known as usury ceilings, usually on consumer and mortgage loans, to protect the economically disadvantaged from unreasonably high interest rates. Until Keynesian ideas started to influence macroeconomic policy, any public concern about interest rates was limited to a microeconomic concern--the level of the rate charged to individual borrowers. A Keynesian macroeconomic view implies a need to manage an economy in order to cushion it from cycles of inflation and recession. Subsequently, a macroeconomic concern about interest rates became part of public policy: managing the interest rate at a level to ensure stable economic growth without periodic bouts of inflation and recession. Not only is interest rate management an integral part of macroeconomic policy, but interest rates are also embedded in the time value of money, a basic principle of modern finance. In most non-Islamic countries, payment of interest is accepted as a routine part of financial dealings.

In the US after the banking crisis that followed the stock market crash of 1929, a regime of regulated interest rates was begun to ensure the safety and soundness of the financial system. Ceilings on interest rates payable on deposits were fixed under what was known as Regulation Q. Globalization of financial markets, increasing competition for deposits and lending opportunities, the rapid pace of innovation in the financial market place and higher inflation rates after the 1960s made Regulation Q ceilings not only outdated but positively destabilizing to the financial system [Cargill p. 134-7 and chs. 12 and 13]. When non-regulated interest rates exceeded Q ceilings, banks and thrift institutions experienced unusual withdrawals of deposits. This disintermediation occurred periodically: in 1966, 1969, 1974-75, 1979-80 and 1982. Similarly, when market rates went above usury ceilings, marginal borrowers were not able to get any credit at all.

The winds of deregulation which swept over other industries finally reached depository institutions in 1980, culminating in the Depository Institutions and Deregulation Act (DIDMCA) of 1980. One of its purposes was to phase out ceilings on interest payable on deposits by 1986; it also preempted state usury ceilings unless a state opted to reinstitute them. While many states have imposed usury limits on credit card rates, credit card issuers have been able to bypass them successfully by locating their credit card operations in other states. One of the major regulatory measures still in force is the prohibition of interest on demand deposits. There are some other interest rate ceilings (on some types of credit and government-insured mortgages) still in force, but these are not serious interventions by the government [Cargill pp. 134 and 283].

Thus by and large, the policy of detailed regulation of interest rates was abandoned in the 1980s in favor of a market-driven system. The only continuing public policy concern seemed to be whether the level of interest rates was such as to generate economic growth without inflation. However, even with deregulation, the microeconomic concern about the reasonableness of rates did not completely disappear. Most of these concerns were based on the old theme of fairness to consumers, although what is fair has remained a tough question to answer. Criticism of high interest rates appeared from time to time [Bogdanich 1985]. Stuhldreher and Ulrich [1989] refer to the US Roman Catholic bishops' pastoral letter "Economic Justice for All: Catholic Social Teaching and the U.S. Economy" (1986) with reference to those least able to pay being charged the highest interest rates. It is not uncommon to hear about interest rates "rip offs" [Wynter 1985] or "gouging" [D'Amato 1991]. The level of interest rates charged seems to continue as an electrifying issue, as demonstrated by the most recent legislative episode relating to capping the interest rate on credit card balances. This article argues that such legislation would represent a retreat into the policies of the past. It would not help the US economy, but would create serious problems in the financial system and the economy.

The Credit Card Interest Cap Proposal

President Bush at a luncheon in New York on November 12, 1991, raised the issue of credit card interest rates: I'd frankly like to see the credit card rates down. I believe that would help stimulate the consumer and get the consumer confidence moving again. [Currier 1991a]

These remarks were not born out of any great concern for rates charged to the poor or disadvantaged; rather they were based on his belief that high interest rates on credit cards were hampering the pace of economic recovery. The economy did not gain much in spite of five discount rate cuts by the Federal Reserve between November 1990 and November 1991.

Apparently the President inserted the line at the last minute, without much consultation with his economic advisers. He also added "Thank God we have people like Al (Senator Alfonse D'Amato) fighting for our values everyday" in Congress [Bacon and Wessel 1991]. Promptly the next day, Senator D'Amato, who had sponsored a bill in 1985 to reduce credit card interest rates, introduced a bill in the Senate to fix the maximum interest rate on credit card balances at 4% above the interest rate charged by the Internal Revenue Service on unpaid taxes. To everyone's surprise the bill passed by an overwhelming majority of 74-19. By the time trading closed on the New York Stock Exchange on November 15, the Dow Jones Industrial Average lost 120.31 points (3.9%), its worst loss in a single day since October 1989 and the fifth largest in its history. It is difficult to say how much of this loss was due to the credit card interest rate issue because there were other factors affecting market sentiment, including the possibility of double dip recession and the prospects of tax cuts when the federal budget deficit is booming [Currier 1991b]. At the same time, it is hard to believe that the issue had no impact on the market. It was probably affected as much by the suddenness with which significant economic policy could be made as with the content of the legislation. Although a recent report by the Securities and Exchange Commission (SEC) concluded that the credit card interest rate cap was not responsible for the stock market drop, some critics said that the report was an ingratiating effort by SEC chief Breeden to exonerate the President [Wall Street Journal 1992]. Others interpreted the move as hostile to business generally [Currier 1991b]. Following the reaction in financial markets, the House of Representatives, which wanted to follow the Senate's lead [Bacon 1991], abandoned attempts to push the issue further. Since the SEC report, Senator D'Amato has announced plans to reintroduce his proposal to cap credit card rates [Wall Street Journal 1992].

Why Single Out Credit Card Interest Rates?

What is unusual about the credit card interest rate controversy is that both the President's remarks and the senator's bill were focused on just one interest rate, that on credit card balances. Why? The President's reasoning was purely macroeconomic, that a cut in this rate will boost consumer spending. Consumption spending in the US accounts for about two-thirds of aggregate spending in the economy. Given that a substantial part of these expenditures are supported by borrowing, it was believed that a cut in credit card rates would spur the pace of economic recovery. Some other reasons surfaced during the subsequent debate. One was the "stickiness" of the rate charged on credit card balances. Most key interest rates (the prime rate, yields on Treasury securities, federal funds rate, Federal Reserve discount rate, interest paid by banks on certificates of deposit and on other deposits) started declining after October 1990. Yet most credit card rates did not change much from their normal range of 18 to 21 percent, thus appearing to be non-responsive to market trends. Moreover, the credit card business seems to be one of the few currently profitable activities for banks, and some have charged that banks were trying to solve their financial problems on the backs of the credit card borrowers [Currier 1991a; Bacon 1991; D'Amato 1991]. Third, most big credit card issuers charge the same rate of interest, making some wonder if the market is competitive. For example, of the ten biggest credit card issuers accounting for about 50% of the market in 1991, seven charged a rate of 19.8% and the other three charged 21%, 17% and 16.2% [Waggoner 1991]. Practically all issuers charge the same rate to all borrowers irrespective of individual risk differences.

Some Possible Reasons for Static Rates

First, in countering the argument that credit card rates have not fallen in line with other rates, it may be pointed out that they had not risen when other rates rose in earlier periods. Second, the rates which have fallen and to which credit card rates are being compared are for very safe loans. For example, the interest rates on treasury borrowing, federal funds, borrowing from the Fed and the prime rate are rates charged to borrowers with little credit risk. Credit card interest rates, on the other hand, have a substantial risk premium built into them, an important point that is sometimes missed. For example, Senator D'Amato complained: "Millions of credit card holders pay banks an average of 18.8% interest, yet receive less than 5% interest on their savings accounts" [D'Amato 1991]. Such a comparison is improper because the savings account has the safety of federal deposit insurance and high liquidity, which credit card lenders do not enjoy. Moreover, many issuers started financing their card operations from sources other than customers' deposits, such as issuing collateralized securities in the market. In these cases, financing is actually done by buyers of these securities, so it is incorrect to say that bank depositors, receiving less than 5% interest, are financing the credit card operations of the banks.

Furthermore, interest costs are not banks' only costs. As interest rates paid by banks have fallen, other costs have gone up, such as the increased cost of deposit insurance, higher capital requirements, and the higher (tougher) requirements for reserves on bad loans. The insurance premiums that banks pay on deposits have gone up in stages from 8.3 cents per $100 of domestic deposits before December 31, 1989 to 23 cents after July 1, 1991, with even higher increases for savings and loan associations. The new risk-based capital standards implemented after December 1990 (with full compliance after January 1993) put consumer loans in the most risky category, requiring the highest capital backing. The declining profitability of banks and the problems of issuing new shares when bank stocks in general have not kept pace with the stock market, forces banks to turn to internal sources to build their capital to required regulatory levels. It is not surprising that they have not reduced the interest rates on credit card balances, one of their few profitable activities. Also, losses from bad loans increase during economic slowdowns. It is possible that lower interest costs during recessions are partly offset by increased losses during this period; similarly, higher interest rates during periods of economic prosperity are offset by reduced expected losses. This may explain why credit card interest rates do not change with other relatively risk free interest rates.

Also, from the banks' point of view, while the strategy of keeping one interest rate for all credit card borrowers has the appeal of simplicity, it can be bad public relations. Under existing policy, the rate is geared to the average risk of the entire group. It is possible to put customers into different risk classes and charge different rates, but while rates will go down for low risk customers, they will rise for high risk customers. It is not certain if the legislators really intended to push rates higher for risky and weaker borrowers. Moreover, some anti-bank sentiment may be due to a possible misunderstanding that every credit card holder pays interest. Since only those who use credit pay interest, the entire interest margin is not a net profit to the banks, because there are processing, billing, mailing and administrative costs, which are incurred on every customer, whether they pay interest or not.

Another interesting explanation for high interest rates on credit cards and their profitability has been offered by Pozdena [1991]. Basically, credit card debt is an unsecured debt; there is no specific asset used as collateral for unpaid balances. There is also a 'moral hazard' in the sense that the issuer has no way of controlling the other debts assumed by the card holder after the card has been issued. While the lender can proceed legally against the general assets or income of the borrower in order to collect delinquent accounts, the costs incurred in recovering could be high relative to the amount to be recovered. Nor does reporting the delinquency to credit agencies help in the actual recovery of debt. Thus, one reasonable alternative available to the issuer is to price the loan assuming maximum potential risk. This results in high credit card interest rates, leaving card holders to self-select whether to pay interest or not. Those who have funds earning lower rates and those who have access to other lower-cost sources of borrowing do not pay the high interest on credit cards, and will use cards only as a payment device. Generally, these will be the card holders with low default risk. The remaining riskier group will use the credit feature and pay the high interest rate. Even for these borrowers, the rate on credit card balances may be resonable compared with the real alternative of borrowing from more expensive sources such as consumer finance companies.

It is a fact of the market that prices come down most in those markets where competition is keenest. For example, banks are very competitive in lending to prime business borrowers because they have lost a substantial part of that business to the commercial paper market. While the credit card market is not that competitive, neither is it monopolistic. For example, while organizations such as Mastercard and Visa provide "interchange" services, issuing institutions set the terms for card holders, including the interest rate. According to one report, there are at least 5,000 issuers of credit cards in the US [Pozdena 1991]. It is also not true that credit card interest rates have not come down. Increasing competition has pushed rates lower on some cards. Some banks are offering lower rates to everyone; there are currently about 16 banks from about a dozen states that offer credit cards nationally with interest rates ranging from 10% to 15.25% [Currier 1991a]. Some banks offer low rates to a small number of customers with a good credit record or with large deposit balances [Pae and Jasen 1991]. However, not everyone would qualify for such low rates. AT&T, which offers a rate of 16.4%, turns away more than 65% of those who apply [Pae 1991].

If many customers have not taken advantage of lower rates, the explanation is consumer apathy. For example, in a recent Wall Street Journal/NBC poll, only 20% of those with cards took the initiative to switch to lower rate cards in the last six months. Another survey found that 40% of the respondents had received an offer of a lower rate card in the mail, but only one in five accepted [Pae 1991].

What explains consumers' seeming indifference to the level of interest rates? For about 25% of the 113 million cardholders, rate differences are not significant because they pay their balances when due. Another 25 do shop around for better rates. But what about the remaining 50%? Some do not shop around because they do not expect to make large interest payments because they either do not plan to revolve their balances or to charge much. This may explain why normal competitive forces have not worked in the credit card market. "The failure of the competitive model appears to be partly attributable to consumers making credit-card choices without taking account of the very high probability that they will pay interest on their outstanding balances." [Ausubel 1991]. For some others (including students and young adults trying to support a certain life style) credit cards are the only source of credit [Pae 1991], and credit availability rather than interest rates will be the main consideration.

Banks should not be expected to compete on the basis of lower rates if consumers do not make their choices on that basis. So another possible explanation for sticky rates is that banks have been engaged in non-price competition: instead of lowering rates, they have been offering cash rebates (Discover), cards without an annual membership fee, free travel insurance, extended warranties on purchases charged to credit cards, and so on.

Problems with Regulated Interest Rates

As already mentioned, the measure to cap interest rates on credit cards was ill planned. The President perhaps did not intend his remarks to be the basis for legislative action. In fact, key Administration officials indicated that such legislation would be vetoed. What is more troublesome are the conflicting signals and trends in policy the gesture implied. After ending the era of regulated interest rates, are we about to reverse direction and go back to regulating them? Confusing signals only create havoc in financial markets:

"Washington must stop disorienting banks with inconsistent messages. All year, bank reform has been debated against a backdrop of alternating calls for regulatory laxity and toughness, depending upon whether recession or deposit insurance enjoyed top priority." [Chernow 1991]

The events preceding the enactment of DIDMCA suggested that the period of effective government regulation of interest rates was over. Globalization of financial markets and innovations in the market place make it difficult for governments to successfully regulate economies without creating serious problems at the same time. Banks were blamed for the excesses of the 1980s; they have also been blamed for not helping bring about a more rapid economic recovery by being responsible for the credit crunch, and for not lowering interest rates on credit cards.

"Because banks function as engines of economic growth, lawmakers would like them to adopt liberal lending policies to revive business. Yet, eager to protect the deposit insurance fund and avert a replay of the savings-and-loan disaster, they would also like bankers to be stern models of fiscal rectitude..." [Chernow 1991]

Should the banking sector bear the blame for recession and the responsibility to end it? These are macroeconomic responsibilities which should not be required of the private sector. Even if Congress and the President believed that reduced borrowing costs would induce a speedier economic recovery, they should have tried to reduce costs to consumers by making all consumer interest fully tax deductible, as it was before 1986. Also, other measures are available to spur the economy. The federal government may not be able to cut taxes to stimulate the economy because of large federal deficits. So, is it fair to ask banks to cut their profits during a period of declining bank profitability?

Another interesting question is: Should legislation compensate for consumer apathy? Will this not promote further consumer apathy and undermine the basic foundation of free markets? In the Senate's measure, the credit card interest cap was fixed at 4% above the rate the IRS charges on unpaid taxes, but neither the base nor the 4% margin has any financial rationale. Nor was there much discussion about the base or the margin.

Would Rate Caps Help the Economy Or Card Holders?

The critical question is whether this legislation would have helped the economic recovery. The stock market's reaction was perhaps one negative indication; most analysts and bank executives felt the measure would have caused more harm than good. It would not have helped in inducing an economic recovery, but on the other hand, had the potential to make it worse. At the same time, some card holders would have been worse off.

For many users, cards are merely a convenient method of payment, and they pay off their balances in full within the grace period. According to one estimate, nearly half the amount charged on Visa cards is paid off within the grace period [Currier 1991a]. To such customers, an interest rate cut would not make any difference. On an estimated average balance of $2,474 in credit card debt [Pae and Jasen 1991] a reduction in interest from 18% to 14% would mean a saving in interest of less than $8.50 a month-hardly a factor to start an economic boom. On the aggregate level, if the proposed cap became law, it would save consumers about $10 billion. If this entire amount was spent, the direct addition to GNP would be 0.2% [Lipin 1991]-hardly enough to start an avalanche of economic growth. There are questions about how responsive consumer spending on credit cards is to interest rate changes. The unwillingness of consumers to shop for the issuers with the lowest interest is perhaps indirect evidence that they are not that sensitive to interest rates.

Interest rates determined in the market place are the mechanism by which free markets allocate funds among competing users. Interest rates on credit cards are only one element in the array of interest rates in a complex economy. Trying to regulate legislatively one rate while leaving the others to be determined by market forces will cause serious distortions in the credit flows within the economy. When the government ushers in an era of selectively regulated rates, the effects of such a policy depend on where such rates stand in relation to the rates that an unregulated market would have fixed. If ceilings are above market rates, they have no operational meaning or significance, but if they are fixed below market rates, thereby reducing potential profits, then funds move into unregulated markets. This is how Regulation Q ceilings on interest paid on deposits led to several periods of disintermediation and reduced the availability of funds in the mortage market. Similarly, usury ceilings in the past resulted in the non-availability of credit to high risk borrowers whenever such ceilings were lower that the rates free markets would have fixed.[1] Furthermore, the interest rate is only one element in the credit card contract, others being credit limits, credit standards, the grace period, membership fees, etc. Attempts to regulate one element of the package through legislation would not leave the other elements intact. Surely, issuers would change those elements still under their control to achieve an optimal balance between risk and return. Such attempts could produce offsetting consequences not intended by the legislation.

The legislation was based on the premise that the only institutional response to interest caps would be a cut in interest rates on credit cards and nothing else. Such an approach ignores the dynamics of market behavior. Kane [1977] coined the word "regulatory dialectic" to illustrate what happens when the regulators ignore the dynamic relations between new regulations and the response of the regulates. Annable also made the same point:

"In banking, for example, applied regulation has operated with an implicit assumption that industry decision making is, in important respects, insensitive to changes in regulation. This static approach introduces irrational behavior into the regulator's decision making models and, when people refuse to behave irrationally, generates results far from the regulators' states goals" [Annable 1989, pp. 325-26].

The measure to cap credit card interest rates shows an indifference to the experience of the immediately preceding period of interest rate regulation that regulations do produce unintended results. What might be some of these unintended consequences?

A legislatively mandated reduction in interest rates could lead to a cancellation of credit card privileges for many people, because some accounts then cease to be profitable. This is evidenced by the fact that banks with the lowest rates on cards are also the ones with stringent credit requirements and reject many applicants [Pae and Jensen 1991]. For some other marginal customers, it could mean reduced credit limits. Banks may try to recover some of their lost profits by instituting higher membership fees, eliminating the standard 25 day grace period and reducing credit limits. Almost all of these steps could lead to a further decline in consumer demand and a further economic slow down.

Conclusion

The recent attempt to legislate ceilings on credit card interest rates would have meant a retreat from the policy of deregulating financial markets. It would not have helped either the economy or credit card holders, but rather would have re-created rigidities in the financial system which had been eliminated before, and would have produced many unintended adverse consequences. Any piecemeal efforts to re-establish controls over individual interest rates or tinker with individual segments of financial markets to achieve some narrow political goals will only lead to unintended problems. Today's complex and globally integrated financial system works best when competitive forces are allowed to operate freely. Although, at the superficial level, credit card interest rates appear to be insensitive to other market rates, in reality the story is more complex. There appears to be some rate competition in recent years. More important, non-price competition is also at work. The credit card interest rate cap episode is a text book example of how some casual remarks can easily get out of hand, and become legislative proposals, without due consideration and analysis of the full consequences. It is hoped that Congress has learnt about the dangers of such measures, and will not attempt anything similar in the near future.

Endnotes

(1.) For an extended discussion of the distorting effects of interest rate ceilings on the financial system and the allocation of credit see Cargill [1991], pp. 134-138.

References

Annable, James. 1989. "The Changing Regulatory Environment; Banking System Risk: Charting a New Course," Proceedings of the 25th Annual Conference on Bank Structure and Competition, Chicago: Federal Reserve Bank of Chicago. pp. 324-43

Ausubel, L. 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, March. pp. 50-81.

Bacon, Kenneth H. and D. Wessel. 1991. "Intense Interest: Credit-Card Furor Will Have Big Effect, Economic and Political," Wall Street Journal, November 18.

Bacon, Kenneth H. 1991. "House Bill on Cap Pushed; Bush Hasn't Decided Yet Whether to Veto Limits," Wall Street Journal, April 8.

Cargill, Thomas F. 1991. "Money, the Financial System and Monetary Policy," 4th ed. Englewood Cliffs: Prentice-Hall.

Chernow, Ron. 1991. "To End Recession, Free the Banks," Wall Street Journal, November 22.

Currier, Chet. 1991a. "Credit-Card Rate Cuts May Not Help," The Muncie Star, November 14.

Currier, Chet. 1991b. "Market Takes Biggest Plunge in 2 Years," The Muncie Star, November 16.

D'Amato, Alfonse. 1991. "Senate Bares Its Teeth at Banks" (Letter to the Editor), Wall Street Journal, November 27.

Kane, Edward J. 1977. "Good Intentions and Unintended Evil: The Case Against Selective Credit Controls," Journal of Money, Credit and Banking, 9, February. pp. 55-69.

Lipin, Steven. 1991. "Economists Say Rise in Credit Card Debt Shows Lower Rates Won't Spur Spending," Wall Street Journal, November 21.

Pae, Peter and G. Jasen. 1991. "Where to Find Lower Credit Card Rates." Wall Street Journal, November 14.

Pae, Peter. 1991. "Credit Junkies: Many Keep on Paying High Rates on Cards Through Bad Planning," Wall Street Journal, December 26.

Pozdena, Randall J. 1991. "Solving the Mystery of High Credit Card Rates," Weekly Letter, Federal Reserve Bank of San Francisco, November 29.

Stuhldreher, Thomas J. and T.A. Ulrich. 1989. "An Ethical Evolution of Interest," Mid-American Journal of Business, 4:1, Spring, pp. 17-22.

Waggoner, John. 1991. "Bad Credit Record Barrier to Low-Interest Plastic," USA Today, November 29.

Wall Street Journal. 1992. "Credit-Card Caps Will Be Sought Again When Congress Convenes," (in special weekly report from the Capital Bureau), January 17.

Wynter, L. 1985. "Too High a Price: Consumers Feel Ripped-Off by Bank Deregulation," Wall Street Journal, October 9.