Developments in the pricing of credit card services.

This article was prepared by Glenn B. Canner and Charles A. Luckett of the Board's Division of Research and Statistics. Wayne C. Cook and Mark A. Peirce provided research assistance.

Interest rates on credit card accounts have typically fluctuated within a natrower range--and at higher levels--than rates for most other types of credit. The contrast receives particular attention when other rates are dropping sharply, which often occurs during periods of economic weakness. At such times, some observers look upon stubbornly high credit card rates as a potential impediment to consumer spending, and therefore to economic recovery, while others regard high rates primarily as an abuse of market power that should be curtailed as a matter of equity.

Since 1972, the average "most common" interest rate on credit card receivables at a sample of banks surveyed by the Federal Reserve has stayed between 17 percent and 19 percent, while rates on most other types of loans, even loans to consumers, have fluctuated over a range of 8 percentage points or more (chart 1).(1) The stability of credit card rates has suggested to some that the credit card market is insufficiently competitive, and has periodically spurred congressional efforts to legislate a national ceiling for these rates. Ironically, the most recent attempt to set a national ceiling, in November 1991, came at a time when competition in the credit card market may have been more intense than at any time in the past, and when more of that competition than ever before was beginning to focus on rates. Since the beginning of 1992, virtually all the nation's largest issuers have reduced rates for all or significant portions of their credit card customers. As will be seen, consumers face a much wider range of interest rates in the marketplace than is generally recognized.

That said, however, it is also true that interest rates on credit card accounts have been stickier than rates for most other types of credit. The following analysis examines possible explanations for their relative rigidity. The historical development of the consumer credit card market is reviewed first, because that history sheds considerable light on some idiosyncrasies of the credit card product and its pricing. The discussion then shifts to the cost structure of credit card operations and the characteristics of consumer demand for credit card services.

HISTORICAL DEVELOPMENT OF THE CREDIT CARD MARKET

Credit cards were first made broadly available to individuals for consumer spending in the early 1950s by major department store chains.(2) The cards were furnished as a convenience to the stores' regular "charge account" customers; they also provided a more efficient means of processing transactions and managing accounts. Customers were expected to pay for charged items in full when they received the monthly bill, and no interest fee was imposed. Retail firms believed that customers might spend more freely if they could "buy now and pay later" and might more frequently shop at stores where they had charge accounts. The firms were willing to receive payment on a delayed basis, and without interest, in exchange for a larger volume of sales. Most stores levied a penalty fee of 1 percent or 1 1/2 percent per month if full payment was not received within the billing period. The fee was set relatively high (compared with general interest rates) as much to discourage customers from making partial payment as to generate income by extending longer-term credit.

Gradually, however, stores became more inclined to allow customers the option of paying either in full or by installments, subject to "interest" or "finance charges" rather than "late fees." Sears and Montgomery Ward were leaders in this shift to "revolving" or "option" accounts, as they found such accounts to be particularly useful in providing a means for consumers to finance purchases of major appliances, which made up an important part of these stores' sales. Previously, major purchases typically had been financed through secured "sales finance contracts," which had to be established and approved separately for each transaction.

Entry of Banks into the Market

Commercial banks eventually began to recognize the potential profitability of providing open-end financing to consumers, many of whom apparently were willing to pay high rates of interest to obtain unsecured credit conveniently. Marketed mainly by banks, the general-purpose credit card for individual consumers came into broad use in the mid- to late 1960s. To make bank cards appealing to consumers who already had department store cards, the banks granted cardholders the same interest-free "grace period" of twenty-five to thirty days that was customary for store cards. However, the banks also imposed servicing fees (called merchant discounts) on card-honoring merchants, mainly smaller retail businesses that were persuaded to accept bank credit cards as a means of competing with the major chain stores.

For many years, bank credit card operations were only marginally profitable, despite interest rates comparable to those on store cards, as start-up and operating costs per dollar of receivables were relatively high and a sizable proportion of cardholders remained "convenience users," paying balances in full each month and thereby avoiding finance charges. To some extent, banks may have been reluctant to impose higher rates than consumers were accustomed to paying on store cards. In addition, statutory limits on rates were in effect in most states until the early 1980s; rates typically were capped at 1 1/2 percent per month (18 percent per year). The ceilings in most states had originally been established for revolving credit at retailers and represented the general consensus among lawmakers about how high a rate businesses needed to charge to cover the cost of providing credit.(3)

Developments in the 1980s

Over the years, the profitability of bank credit card operations improved as operating efficiencies were developed and as credit cards were distributed and used more widely. When profits came under intense pressure in the late 1970s and early 1980s from sharp inflation-induced increases in funding costs, institutions began imposing annual fees on credit cards to supplement income from interest. Many also adopted more restrictive lending practices, which had the effect of curbing the growth of credit card use temporarily. Meanwhile, state legislatures one by one moved to raise or remove the ceilings on credit card rates.

The spread of credit card rate deregulation was triggered partly by a 1978 Supreme Court decision (Marquette National Bank v. First of Omaha Service Corporation), which held that a nationally chartered bank may provide credit at the rate ceiling of the state in which it is located, regardless of the ceiling in the borrower's state. In the early 1980s, several banks moved their credit card operations to states that had raised or removed rate ceilings on credit cards.(4) Currently, sixteen states do not specify ceilings and fourteen specify ceilings above 18 percent per year.

These developments helped restore profitability to the industry, and, as funding costs moved substantially lower in the mid-1980s, credit card operations became highly profitable. Responding to increased profitability, many banks, especially those operating nationwide, became much more aggressive in marketing credit card accounts, both by relaxing credit standards and by offering more card "enhancements," such as travel accident insurance, auxiliary rental car insurance, and other distinctive features that varied among issuers. The enhancements initially were available mainly on "premium" card plans, which charged higher annual fees and, in many cases, somewhat lower interest rates; more recently, some combination of enhancements has been available with nearly all "standard" plans as well. In addition, over the past few years, individual institutions have increased the number of different plans they offer; many of the new plans are targeted at selected subsets of consumers, and many charge lower interest rates. At the same time, nonbank firms, such as AT&T (Universal Card), Sears (Discover Card), and American Express (Optima Card), have gamered significant market shares, in part by differentiating their plans by forgoing annual fees or by offering rebates on purchases or discounts on selected services.

Current Industry Structure

Today, although the largest institutions command a sizable share of the total market, thousands of issuers provide credit cards. Approximately 6,000 commercial banks and other depository institutions market general-purpose credit cards (predominantly under the VISA or MasterCard label), each setting the terms and conditions on the cards they issue.(5) Another 12,000 depository institutions act as agents for issuers and distribute credit cards to consumers. Major retailers continue to provide store-specific credit cards; Sears' store card, for example, is estimated to rank second in total receivables among all types of cards. Many smaller retailers have given up direct management of their credit card operations but provide store-identified cards to their customers through "private label" programs managed and funded by other institutions.

Given the large number of institutions competing in the credit card market, it is not surprising that consumers are offered a wide variety of plans. The diversity is often overlooked in public discussions, which tend to focus on a national average rate or on prominent high-rate plans. However, the Federal Reserve's semiannual E.5 statistical release, The Terms of Credit Card Plans, reveals some of this diversity, which extends to rates as well as other terms. The E.5 release provides detailed data on credit card plans at more than 150 institutions, primarily commercial banks that operate large credit card programs. Seventeen percent of the issuers included in the March 1992 E.5 release charged rates below 16 percent per year. Nearly one-fourth offered variable-rate plans (plans that tie the interest rate to an index, such as the prime rate, that normally moves in line with other interest rates); an additional 4 percent offered plans with a tiered rate structure, in most cases assessing lower rates on higher balances. Undoubtedly, the variety in the marketplace is even greater, as the survey on which the E.5 release is based asks institutions about only their largest plan.(6)

CURRENT CREDIT CARD HOLDING

In the thirty years or so since commercial banks entered the market in significant numbers, the credit card has become a familiar financial tool to the vast majority of American families. Today, roughly 70 percent of all U.S. families have at least one credit card account, up from about 50 percent in 1970 (table 1). Most card-holding families, in fact, have several different accounts. A 1989 survey of consumers sponsored by the Federal Reserve found that three-quarters of card-holding families had more than two credit card accounts, with the average number of accounts held by all card-holding families approaching six.(7)

Not only has credit card holding become much more prevalent in the past twenty years, but the types of cards held have changed dramatically (table 1). In particular, the holding of bank cards (defined in the survey as "bank type" cards, including VISA, MasterCard, Discover, and Optima) has risen substantially. In 1977, 38 percent of all U.S. families had a bank card, up from 16 percent in 1970. By 1989, the proportion had increased to 54 percent. Bank-card holding likely has edged up since then, with the development of major new plans by recent entrants into the market and continued growth in the operations of longtime market participants.

In contrast to bank cards, the holding of credit cards issued by retail stores has expanded very little in recent years. In 1970, store cards were held by 35 percent of all families; the proportion had jumped to 54 percent by 1977 but has risen little since then.

FUNCTIONS OF CREDIT CARDS

Credit cards serve two distinct functions for consumers: a means of payment and a source of credit.(8) Consumer sensitivity to various aspects of credit card pricing reflects these two types of use.

Credit Cards as a Means of Payment

Although cash and checks continue to be the dominant means of completing transactions, credit cards are an important and growing alternative. In 1990, according to one private-sector source, credit cards were used by consumers to purchase some $445 billion worth of goods and services. In that year, credit card charges accounted for about 13 percent of all consumer expenditures, up from 10.8 percent in 1980.(9)

The growing share of consumer expenditures completed by credit card attests to the advantages of this means of conducting transactions, including convenience, safety, automatic recordkeeping, and, in most cases, an interest-free grace period for settling accounts. Although some card issuers charge consumers a fee for each purchase, most do not (fewer than 2 percent of the roughly 160 issuers covered by the March 1992 E.5 statistical release assessed a transaction fee on each purchase). On many plans, cardholders are assessed an annual fee to hold a card, but most annual fees are unrelated to the volume and frequency of purchases.

Consumers who use a credit card principally as a payment device most likely would, in selecting a card, focus on the level of any annual fee, the length of the grace period, the availability of desirable enhancements, and the level of authorized charges (the credit limit). The stated interest rate is unlikely to be of much importance to consumers who view their cards mainly as a transactions device.

Credit Cards as a Source of Credit

The interest rate charged may be more critical to consumers who view a credit card as a debt instrument and regularly roll over part of their balances to future billing periods, incurring interest charges to do so. Credit cards today account for a substantial and growing share of consumer installment debt (chart 2). Revolving credit (mainly outstanding balances on credit cards) stood at $60 billion at the end of 1980, representing 19 percent of all consumer installment debt. By the end of 1991, revolving credit had risen to more than $240 billion and accounted for roughly one-third of consumer installment debt outstanding. The portion of this amount that represents convenience use is unknown, as it is impossible to break down the aggregate statistics into balances owed by different types of users. No doubt a substantial portion of outstanding balances at any one time are accruing interest charges. However, even people who use credit cards as a means of borrowing may differ substantially in the specific ways they use their cards. As is discussed later, these differences can bear significantly on the interest rate sensitivity of consumers and the nature of competition in the credit card market.

COSTS OF CREDIT CARD OPERATIONS

Both the level of credit card interest rates and the changes in rates over time reflect the costs of providing credit card services. Therefore, an understanding of the behavior of credit card interest rates rests in part on an examination of costs. Two aspects of the cost issue warrant particular attention: comparative performance across product lines and comparative performance among different card issuers.

Differences Across Product Lines

The cost structure of credit card operations differs significantly from the cost structures of other types of bank lending. On balance, credit card activities involve much higher operating costs and greater risks of default per dollar of receivables than do other types of bank lending. In addition, the cost of funds is a relatively less important component of the total cost of credit card operations than it is for other types of credit.

The degree of credit risk is a key feature that distinguishes credit card lending from most other bank lending. Credit extended through credit cards, unlike most other forms of bank credit, is unsecured. (10) Once available, a line of credit is exercised at the cardholder's option, and the card issuer has little control over how leveraged the cardholder may become through additional borrowing elsewhere. A cardholder may be inclined to use the credit line under conditions least favorable to the lender, that is, when the cardholder's net worth is low or his liquidity is impaired (due, for example, to loss of employment).

Data on bank charge-off experience (net of recoveries) for credit card and other types of bank lending illustrate the relatively high loss rates associated with credit card lending (chart 3). Over the past decade, the credit card charge-off rate has consistently exceeded the charge-off rate for bank lending as a whole. At the end of 1991, for example, the charge-off rate for credit card loans was roughly double the rate for total bank lending. Moreover, the data on credit card charge-offs seem to reveal a secular trend toward higher losses, likely reflecting the relaxation of credit standards and the sizable expansion of card issuance during the 1980s.

Information on the costs and revenues associated with the credit card operations of a sample of card-issuing banks is available from the Functional Cost Analysis (FCA) program, a nationwide cost-accounting system operated by the Federal Reserve Banks (table 2). The program provides similar information on other kinds of credit extended by participating depository institutions, including installment, real estate mortgage, and commercial lending.

Although advances in automated processing have substantially improved operating efficiency over the years, the costs associated with processing a large volume of relatively small transactions and of servicing a large number of accounts make credit card operations more costly per dollar of receivables than other types of bank lending. As noted, losses on credit card plans (including losses due to fraud) have also been higher than losses on other types of credit.

In 1991, the costs of credit card activities totaled about 23 percent of outstanding balances at FCA-participating banks. Operating costs (including such diverse activities as servicing accounts, soliciting new customers, and processing merchant credit card receipts) accounted for nearly 60 percent of the total cost, and the cost of funds 27 percent.

The cost picture at FCA-participating banks was considerably different for other types of bank lending. Overall costs for mortgage, commercial, and installment loans totaled between 8 percent and 10 percent of outstanding balances. Operating expenses for these products amounted to 1.4 percent to 3.4 percent of outstanding balances and accounted for between 18 percent and 33 percent of total costs. The cost of funds, on the other hand, accounted for 60 percent of total expenses for installment lending, about 70 percent for commercial lending, and nearly 80 percent for mortgage lending.

These data suggest that credit card issuers must generate relatively higher levels of revenue per dollar of receivables to cover costs than is necessary for other types of lending. Although card issuers obtain noninterest revenue from merchant discounts and from a variety of fees (such as annual membership fees, penalty charges, and fees for cash advances), the amount is not large enough in most instances to eliminate the need for substantial interest income from credit cards. Furthermore, interest actually received on credit card balances is much less than the stated rate might indicate, because convenience users generate little or no revenue from finance charges. In 1991, the gross interest return on credit card receivables for FCA-participating banks was about 15 percent. The FCA does not collect data on the stated interest rates on credit cards issued by program participants, but other sources indicate that, industrywide, stated rates during 1991 generally ran between 16 percent and 20 percent.

Differences Among Card Issuers of Different Sizes

Cost structures differ not only across product lines, but also among card issuers. The differences reflect, among other factors, the scale of operations and the underlying level of credit risk the issuer is willing to accept. (11) Although the FCA program is the only source of data for comparing cost and revenue among different bank credit products, it is dominated by small and medium-size institutions (overwhelmingly, institutions having less than $1 billion in assets) that offer a wide range of services to the public. Because none of the nation's largest credit card issuers currently participate in the program, the FCA data do not indicate the extent to which the cost and revenue structures of the largest card issuers differ from those of smaller card issuers.

Comparison of FCA data and a combined income statement derived from a nationally representative cross section of VISA and MasterCard issuers does, however, provide some insight into the differences between the FCA banks and the larger issuers that tend to dominate industry statistics (table 3). Several differences between the FCA data and the VISA and MasterCard data are worth noting. Operating expenses account for a much smaller proportion of the total cost for the large issuers than for the FCA banks, while credit losses and the cost of funds account for larger proportions of the total cost (and are higher per dollar of receivables) for the major issuers. These differences suggest that large card issuers enjoy some benefits of economies of scale in their operations and that, as a group, they accept a wider range of credit risks in building their credit card portfolios. The differences in funding costs may reflect differences in the source of funds: Large issuers tend to rely more on managed liabilities (such as large time deposits or commercial paper), whereas smaller issuers use less-expensive retail deposits more heavily.

INTEREST RATE RIGIDITY

Although the cost data in tables 2 and 3 help explain the relatively high level of credit card interest rates generally, and also point to some of the reasons for the differences in credit card pricing among issuers (and among the various plans offered by a single issuer), they do little to explain the rigidity of credit card interest rates in the face of changes in funding costs over time. Rates might be expected to fluctuate with changes in funding costs regardless of the width of the gap between the rate charged to cardholders and the marginal cost of raising funds. Only if changes in other costs moved systematically to offset changes in funding costs (or were expected to move in this direction) would it seem reasonable for rates charged to remain stable when funding costs move sharply.

Of course, if funding costs were a trivial component of total credit card costs, there would be little reason to expect rates to move noticeably with changes in funding costs. In fact, funding costs in recent years have accounted for roughly 25 percent to 50 percent of total costs of credit card operations, depending on the size of the program (table 3). Although certainly not a trivial proportion, it is considerably smaller than for some other types of lending. Therefore, it is more likely that noninterest costs will play a larger role, and funding costs a smaller role, in the behavior of credit card rates than in the behavior of rates on other types of lending.

There is little apparent reason to believe that operating costs would move substantially in an offsetting direction to funding costs; however, some basis exists for thinking that the costs of bad debts might behave that way.(12) General interest rate levels are typically driven down during times of economic sluggishness, which also tend to be times when delinquencies and write-offs on credit card accounts are climbing. The most recent period of decline in market interest rates is a case in point. Delinquency rates on credit cards began a sharp rise in 1990 and continued at high levels through 1991.(13) Data on charge-off rates from VISA U.S.A. further document the recent recession-related acceleration in credit card losses and suggest that loss rates are generally higher for credit card accounts than for other bank lending (chart 3).(14)

The historical unresponsiveness of credit card rates to general rate movements, however, seems to reflect special period-specific circumstances as much as any particular recurrent condition. In the 1960s and into the 1970s, funding costs were relatively stable while operating costs moved through a high-cost start-up phase into a period of increasing efficiency. As discussed earlier, bank cards initially were priced in line with store cards and earned rather meager profits; as operating efficiency improved, rates held steady instead of declining with costs, and profits rose from low levels. It was not until the inflationary period of the late 1970s and early 1980s that market interest rates soared and deregulation of rates on deposits led to sharp increases in funding costs. At that time, however, statutory ceilings prevented much upward adjustment of credit card rates, and by the time states acted to raise ceilings, interest rates generally had crested. When funding costs began to decline significantly after 1981, credit card rates remained mostly at their existing levels, in part because they had been constrained from rising to an equilibrium level when funding costs were climbing; the decline in funding costs tended to restore equilibrium. In addition, demand for credit card credit rose sharply after 1982, as is evident in the rapid growth of such borrowing as the economic recovery picked up steam. The strong demand allowed credit card issuers to expand their receivables without having to compete intensively for market share, minimizing the pressure to reduce prices.(15)

By 1984, the profitability of credit cards had risen above that of most other forms of lending, and it remained relatively high through the end of the decade. This rather long period of high profits raises the question of why competition did not at some point exert heavier downward pressure on credit card rates. One possible answer is that, as banks broadened the market by distributing cards to individuals of lower creditworthiness, a larger risk premium was incorporated into the rate structure, tending to keep rates up. The persistently high credit card interest rates in the latter half of the 1980s may have reflected anticipation of higher credit losses, but the unusually long economic expansion postponed the realization of those expected losses. (16)

CREDIT CARD PROFITABILITY

Data on the performance of credit card operations suggest that higher levels of credit card delinquency and default have raised the costs of credit card operations in recent quarters. A reduction in the cost of funds during the same period, however, has largely offset the losses, helping to maintain relatively strong earnings for the industry as a whole.

Table 4 summarizes historical data from the FCA on the net before-tax earnings on credit cards and other types of credit of small and medium-size banks. The table also provides data on credit card profits of large credit card banks compiled from the FFIEC (Federal Financial Institutions Examination Council) Report of Condition and Income.(17) On average, for the period 1974-91, earnings of banks participating in the FCA were slightly lower for credit cards than for other types of credit. For these institutions, credit card earnings were considerably more volatile than earnings on installment or real estate loans (as measured by the standard deviation) and were comparable in volatility to commercial lending. On the whole, earnings on credit cards at these small and medium-size institutions do not appear to have been out of line historically with other lending activities. Credit card earnings did outpace income from other sources over the years 1984 through 1987, but other loan products had similar runs of higher-than-average earnings at other times.

The data for the large credit card banks suggest a somewhat different pattern of recent experience. Compared with the FCA banks, the large credit card banks earned similar or higher returns from 1986 through 1990, but reported earnings dropped below the earnings of FCA banks in 1991. The different experiences of the two groups of card issuers may be related to theft selection of customers. The large credit card banks have typically solicited more marginal credit risks than the smaller institutions. The difference is reflected in the loan loss experience of the two groups. While FCA banks have had annual fraud and credit losses of about 2 percent of outstanding balances during most of the past decade, the large credit card banks have had consistently higher losses, generally between 3 percent and 5 percent of outstanding balances. These differences suggest that the large credit card banks are selecting a different point on the risk-return frontier than their smaller counterparts. Consequently, it would be expected that when the economy is performing well, as it did during the mid-1980s, issuers that bear more risk would outperform more conservative issuers. In weak economic periods, such as the most recent one, however, the performance of large issuers would be expected to suffer from sharply rising credit losses.

CONSUMER SENSITIVITY TO INTEREST RATES

Full exploration of the behavior of credit card rates requires an examination of the demand side of the market as well as the supply side. In general, one would expect markets where buyers are highly sensitive to price (in this case, to interest rates) to exhibit more competition in pricing than markets for products where some other attribute, such as convenience or the level and quality of service, is the overriding concern.

Whether credit card issuers compete to attract and hold customers by lowering interest rates depends in part on the sensitivity of current and potential cardholders to differences in rates among issuers. The repayment habits of cardholders are, in turn, a key determinant of their responsiveness to interest rates charged.

Implications of Information Theory

Information theory provides a useful framework for assessing the interest rate sensitivity of prospective and current cardholders.(18) The theory postulates that consumers will continue to seek information about the prices and attributes of a product up to the point at which the additional cost of obtaining information equals the additional benefit they may gain from their extra search effort. Therefore, it is postulated that a reduction in the time, effort, and cost associated with the search for information will promote additional product shopping.(19) It is also axiomatic that the effort consumers put into the search will rise as the potential benefit to them increases.

Information theory implies that certain types of cardholders are more likely than others to be sensitive to, and to shop for, lower rates. Consumers who regularly borrow large amounts on their credit cards would seem more likely to search extensively and to apply for cards having low finance rates than cardholders who rarely carry a balance from month to month or carry forward only a small balance.

Repayment Practices

Users of credit cards fall into two broad categories--convenience users and revolvers. Convenience users are those who usually pay off their balance in full during the interest-free grace period, thereby avoiding finance charges; revolvers are those who usually do not pay their balances in full and thereby incur finance charges.

Credit card users may occasionally deviate from their usual repayment pattern: Convenience users might repay an unusually large purchase in installments, or an unforeseen income disruption might cause them to alter their customary behavior; revolvers might sometimes repay their outstanding balance in full, for instance, when they receive a Christmas bonus or a tax refund, or when they consolidate debts.

Several consumer surveys have explored the repayment practices of cardholders and have obtained highly consistent results over time. In surveys sponsored by the Federal Reserve in 1977, 1983, and 1989, roughly half the families that reported using credit cards said that they nearly always paid their bill in full each month.(20) The latest of these surveys, however, also indicates that a higher fraction of cardholders are revolving balances at any one time than their responses to questions about customary repayment practices suggest. The 1989 Survey of Consumer Finances found that 60 percent of surveyed cardholders had carried over balances from the previous month (table 5); industry statistics generally show that about two-thirds of accounts are revolving at any point. Nonetheless, the important factor is how consumers perceive their own behavior, as it is this perception that will guide their credit-shopping activities and their sensitivity to credit card interest rates.

Information theory suggests that revolvers would be much more likely than convenience users to be sensitive to the level of the interest rate assessed on credit cards, although convenience users may be quite sensitive to the amount of the annual fee and the length of the interest-free grace period. Results of a 1986 survey of cardholders by Payment Systems, Inc. (PSI), support these implications of information theory.(21) The survey found that revolvers were more likely than convenience users to read credit card solicitation materials, and a larger proportion of revolvers said that they would apply for a card with a lower rate if it were offered.

The PSI survey also found that the larger the outstanding balance a revolver carried, the more likely the cardholder would be to apply for a lowerrate card.(22) In this context it is important to note that, although the amount of credit card debt owed by cardholders who revolve varies substantially, a large fraction owe relatively small amounts. The 1989 Survey of Consumer Finances, for example, revealed that, among cardholders with debt, 32 percent owed less than $500 at the time of the survey, and an additional 18 percent owed between $500 and $1,000 (table 5). Thus, a significant number of those who use credit cards as a borrowing device may have balances small enough to render the interest rate a secondary consideration in deciding which cards to hold.

Practical Considerations

The foregoing analysis implies that one reason credit card rates have not varied greatly over time is that a large proportion of cardholders are likely to be relatively insensitive to the finance rates charged on their cards. Interest rates are largely irrelevant, of course, for convenience users. But even for many who revolve balances, the dollar amounts at stake may be fairly small. For example, for a family owing the median amount of credit card debt in 1989--roughly $1,250 (table 5)--a 3 percentage point drop in the rate would reduce the annual interest charge by less than $40. It is questionable whether a $40 annual saving would be enough to induce a cardholder to switch from a card that has been providing satisfactory service or attractive enhancements.

There are other reasons cardholders might be relatively insensitive to interest rates. In many instances, the credit limit is lower on a newly issued card. Also, there is no guarantee that the rate on the new card will stay low, or that the new card issuer's performance on such key matters as avoiding or rapidly rectifying billing errors will measure up to the previous card issuer's record. Factoring in other disutilities of switching cards, such as the nuisance of filling out applications and comparing the nonrate features of different cards, the inertia of many cardholders with respect to rate differences does not seem unreasonable. (23)

Finally, some cardholders, including a portion who carry high levels of credit card debt from month to month, may be willing but unable to switch to credit card plans that offer reduced rates because they cannot qualify for these plans. Poor debt repayment records or high levels of debt relative to income make these potential switchers relatively unattractive high-risk prospects to issuers of lower-rate cards.

Applicable Studies of Price Stickiness

Historically, the credit card industry has generally regarded consumers as unresponsive to rate incentives. In this view, cardholders are not likely to increase their borrowing very much in response to a reduction of 1 or 2 percentage points in the interest rate, and, for the reasons outlined earlier, most of them are thought unlikely to switch cards to save on interest payments. Expecting to gain relatively little incremental volume from either new or existing cardholders by lowering rates, issuers have had minimal economic incentive to reduce rates to the broad spectrum of their cardholders (as opposed to selected subsets of customers). Lowering the interest rate on standard card plans would reduce interest revenue on balances of all existing cardholders who revolve their accounts-- customers who apparently were willing to pay the original rate. (In contrast, for most other types of loans to individuals, when a bank changes its rate quotation, the new rate is available only to new borrowers. A reduction in auto loan rates, for example, does not result in a loss of revenue on existing loans.)

Julio Rotemberg and Garth Saloner have shown that a relatively inelastic demand for a product can lead to price stickiness for both price increases and decreases, as long as there is some positive cost to suppliers associated with changing prices. (24) They argue that firms that face more inelastic, or "steeper," demand curves gain less than other firms by changing prices from a level that does not maximize profits to one that does. For such firms, any given divergence between the price currently charged and the profit-maximizing price involves less of a divergence between the current quantity and the profit-maximizing quantity. If, in fact, credit card issuers face a relatively inelastic demand, owing to high costs to consumers of switching cards (or for any other reason), and because issuers would incur some cost by changing rates, reductions (or increases) in funding costs may not bring about commensurate changes in rates. (25) According to this reasoning, the gain from changing prices simply may not justify the cost of doing so for firms facing relatively inelastic demand curves.

A somewhat different demand-side explanation for the stickiness of credit card interest rates has been proposed by Lawrence Ausubel.(26) Ausubel recognizes cardholder "switching costs" as one deterrent to rate competition, but he attributes most of the rate insensitivity to a certain peculiarity of cardholder psychology. Many people, Ausubel believes, do not expect to revolve their balances when they acquire a card, and therefore are not concerned with the interest rate charged. Some, in fact, do turn out to be true convenience users who pay no finance charges, but a large segment of these cardholders, Ausubel argues, wind up making only partial payments and incurring interest costs after all. These customers are attractive to a credit card issuer, but, because the customers do not expect to pay interest, the issuer need not solicit their business with a low rate. The problem with this argument is that it depends on cardholders persistently misperceiving their own behavior. Although it may be reasonable to believe that many consumers first acquire a card with erroneous expectations about their future payment habits, it is harder to argue that they will in fact regularly revolve their balances and yet' maintain the assumption that they will not do so in the future. At some point, it would seem, such cardholders might recognize their actual payment patterns and seek out a low-rate card--if, that is, dollar differences in interest costs were really large enough to matter to them.

RECENT COMPETITIVE DEVELOPMENTS

Several reasons for the relative rigidity of credit card interest rates in the past have been cited here. Historically, special conditions, such as high startup costs and state-mandated rate ceilings, have stifled movements of credit card rates. On the supply side of the market, changes in funding costs are less important to credit card operations than to other credit activities, and the risks inherent in this unsecured form of lending seem generally to increase at times when costs of funds are declining. Because funding costs account for a comparatively small part of total costs for credit card programs, the favorable effect of declining funding costs is more likely to be offset by increases in other costs. On the demand side, credit card users have tended to be relatively insensitive to interest rate levels in their decisions to acquire or to keep a particular card. Consequently, card issuers have tended to compete on factors other than price.

In the past several months, however, much of the rigidity in credit card pricing has been breaking down, with a growing number of issuers reducing rates 2 to 4 percentage points. This development has not been readily apparent in published measures and lists of credit card rates, in part because lower rates have been made available to selected groups rather than across the board.

Exerting downward pressure on credit card rates has been an unusually steep decline recently in the cost of funds, possibly coupled with a charge-off experience during the 1990-91 recession that may have been less damaging than allowed for in past pricing decisions. For example, rates that banks pay on certificates of deposit of various maturities have dropped as much as 3 percentage points since the middle of 1991, the sharpest decrease in this key element of funding costs in a decade. Meanwhile, the rise in delinquencies and charge-offs during the latest recession appears not to have greatly exceeded increases during other periods, despite the expansive lending practices of the preceding few years. Perhaps reassured by this relatively favorable loss experience, card issuers may now be willing to build a smaller margin for potential write-offs into rates charged. Thus, as a result of both sharp declines in funding costs and a more optimistic assessment of risk, issuers may believe that they now have more latitude to reduce rates than they have had before.

Another factor that may be applying downward pressure on credit card rates is the increased difficulty of acquiring new customers in a relatively mature product market. The great expansion in card holding during the 1980s has brought the market nearer to saturation, making it more costly to attract new customers without offering substantial enhancements, waiving annual fees, or accepting greater credit risks. The high costs of attracting new customers in a competitive, saturated market places a premium on retaining existing customers, particularly those who revolve balances and pay on time. Reducing rates is one way to curtail attrition.

For the most part, card issuers have lowered rates selectively. In some cases, they have targeted their solicitations to individuals deemed to have certain desirable characteristics, an approach made more feasible by the development of extensive data bases and improved techniques for screening potential cardholders. Some of the largest national issuers have segmented their cardholder bases according to risk characteristics, offering reduced rates to a select group of existing customers who have good payment records; higher-risk late-paying customers are still charged higher rates. (27) Many of the lower-rate programs involve variable rates; because the rates on such accounts change automatically as the index rates move, the use of variable-rate procedures avoids some of the regulatory and public relations problems involved in raising rates (when funding costs rise) under a fixed-rate plan.

In addition to these supply-side developments, some increase in consumer sensitivity to rates is probably also contributing to the recent reductions in credit card rates. Whether the relative importance of interest rates to consumers has changed is not clear--such factors as service or enhancements may still carry more weight with most cardholders. However, spreads between credit card rates and rates received by consumers on deposits or other interest-beating assets are wider than they have been for two decades. Moreover, with nonmortgage interest payments no longer deductible on federal income tax returns, a given rate of interest is effectively higher than in the past for those who itemize deductions. Therefore, other things equal, cardholders likely are more prone to respond to lower-rate offers than they have been in the past. In addition, the weak economy of the past two years has forged a thriftier, generally more cautious consumer, one more likely to be concerned about the size of interest payments. Increased media attention to the topic and the widespread availability of lists comparing rates charged by different issuers have probably fostered at least some increase in overall awareness of credit card rates.

An important catalyst increasing the focus on rates as a marketing tool has been the willingness of some prominent card issuers to take the lead. AT&T's entrance into the market as an aggressive price competitor has been significant. The firm's emphasis on price has been exemplified first by its offer to "charter members" of a lifetime exemption from annual fees, and lately by its heavy advertising of the declines in rates for all cardholders resulting from its variable-rate formula. After American Express introduced its risk-based pricing structure for the Optima card in February 1992, other major issuers lowered rates in some fashion to some customers. One reason these actions are not more evident in published averages is that in most cases issuers have kept rates for the largest portion of their standard plan customers at their previous levels. The Federal Reserve's series for the national average bank-card rate mentioned earlier, for example, includes a bank's "most common" rate, and that rate is still usually the bank's high standard-plan rate.

Card issuers also may have felt pressure to reduce rates in the aftermath of a brief effort in the Congress in November 1991 to legislate a national ceiling on credit card rates. A bill to do so was passed by the Senate but did not become law. How critical a role that effort played might be questioned, however, in view of the lack of any discernible effect from a similar attempt to control rates in 1986, when two such bills were proposed. Coming at a time when other forces were working to lower rates, however, the recent congressional attention may have hastened the process.

In the future, segmented rate structures will probably become more widespread as lenders continue to try to categorize accounts by their profitability and to price them accordingly. Flexibility in rates will likely persist, with more issuers converting to variable-rate plans or offering a choice of fixed- or variable-rate plans. "Quantity discounts" whereby lower rates are charged on higher balances may become more common as well. Further consolidation in the industry seems likely, too, as less-efficient operations are sold to lower-cost issuers. Nevertheless, levels of credit card rates seem certain to remain comparatively high, because revenues still will have to be large enough to cover comparatively high operating and default costs.

1. The survey asks banks to report the rate that applies to the largest dollar amount of their credit card receivables (in other words, the "most common" rate) during the first full week of the middle month of each quarter. A simple unweighted average of the responses is calculated as an estimate of the average rate on credit card accounts for the banking industry.

2. Some hotels were issuing credit cards to regular patrons as early as 1900, and some department stores and gasoline companies were issuing cards before 1920. The practice was very limited, however, and was restricted to the most highly valued customers. Relatively wide distribution of credit cards did not occur until after World War II. The major "travel and entertainment" cards (American Express, Carte Blanche, and Diners Club) were established in 1949 and 1950. Although initially issued mainly to individuals for business-related use, often through the recipient's employer, these cards helped set the stage for the introduction of general-purpose bank-issued credit cards.

3. State-legislated ceilings on rates are, in fact, a hodgepodge of laws designed to facilitate consumer lending by casing earlier restraints on interest rates. At the turn of the century, most states had a single law or constitutional provision that established a limit on the "legal rate of interest," often 5 percent or 6 percent per year. As installment sales contracts for automobiles and other consumer durable goods were being developed in the present century, state legislatures recognized that higher rates would have to be permitted to cover the costs of installment lending, and in most states a series of laws evolved that established higher ceilings for certain types of consumer lending. Department store credit card programs typically operated under a state' s "retail installment sales act," which authorized a "time price differential" that was defined to be legally distinct from "interest" and in most states was set at a maximum of 1 1/2 percent per month.

4. In March 1980, for example, South Dakota raised its ceiling on credit card interest rates to 1.65 percent per month (19.8 percent per year), and Citicorp promptly moved its credit card operations from New York to that state. New York at the time permitted 18 percent per year on balances up to $500, but only 12 percent on balances above $500. Between 1980 and 1985, fifteen states removed their ceilings (including South Dakota a year after it raised its ceiling), and many other states raised their ceilings to levels well above those needed to cover costs (including New York, which now has a ceiling on credit card rates of 25 percent per year).

5. VISA and MasterCard run the two primary systems for settling interbank accounts, that is, between banks that process charge slips submitted by merchants and banks that extend credit to cardholders. Although VISA and MasterCard operate the interbank settlement systems and collect fees for these services from banks, they do not control the terms these banks offer to cardholders and merchants.

6. The E.5 statistical release is available from Publications Services, mail stop 138, Board of Governors of the Federal Reserve System, Washington, DC 20551. A single copy can be obtained without charge; a subscription costs $5 per year. The E.5 release is also available at the roughly 1,300 libraries in the Government Depository Library System.

7. 1989 Survey of Consumer Finances, sponsored by the Federal Reserve in cooporation with other agencies. The data are available on request from the National Technical Information Service, 5285 Port Royal Rd., Springfield, VA 22161.

8. Credit cards also have become important as a source of identification and as a convenient means of making reservations (for example, for hotels, automobile rental, and travel).

9. The Nilson Report, no. 499 (May 1991), p. 3.

10. Not all credit card debt is unsecured. A "secured credit card account" is a relatively new product tailored to individuals who have low incomes or poor credit histories. Applicants for such cards deposit money ($500 to $1,000 or so) in a savings account that serves as collateral for the credit line and typically pays the passbook rate of interest. The advantages of such an arrangement to the consumer would seem limited, though not nonexistent. Although holders of secured accounts in essence pay a premium to borrow their own money, they do benefit from the liquidity and convenience that credit cards provide; in addition, such accounts can help some individuals establish a credit history or repair a poor credit record.

11. For a discussion of economies of scale in credit card operations, see Christine Pavel and Paula Binkley, "Costs and Competition in Bank Credit Cards," Federal Reserve Bank of Chicago, Economic Prospectives, vol. xi, no. 2 (March/April 1987), pp. 3-13.

12. some types of operating expenses may move in a counter-cyclical manner, particularly if costs associated with the servicing of accounts rise with delinquencies. Moreover, rates of response to credit card solicitations may fall when economic growth stalls, increasing the cost of acquiring new accounts as well.

13. American Bankers Association, Consumer Credit Delinquency Bulletin (Washington, ABA, quarterly repons, 1981-92).

14. For further discussion of the relationship between credit risk and interest rate stickiness, see Alexander Raskovich and Luke Froeb, "Has Competition Failed in the Credit Card Market?" U.S. Department of Justice, Antitrust Division, Economic Analysis Group Discussion Paper EAG 92-7 (June 12, 1992).

15. In commenting on the surge in credit card debt in the mid-1980s, Christopher DeMuth remarked, "It is, however, consistent with the operation of competitive markets for firms, faced with declining costs and growing demand, to expand output and improve product quality at a constant market price. That is just what happens when a credit card issuer offers more features and larger credit lines" (p. 230). See Christopher DeMuth, "The Case Against Credit Card Interest Rate Regulation," Yale Journal on Regulation (Spring 1986), pp. 201-42.

16. Randall Pozdena has developed an option-pricing model of credit card interest rates that emphasizes the credit risk inherent in lending through unsecured lines of credit. Pozdena found that an options-based model fit actual data well: Credit card rates showed little response to T-bill rates, and model parameters were "consistent with the representation of credit card debt as costly-to-service, unsecured credit extended to relatively high-risk borrowers." See Randall Pozdena, "Solving the Mystery of High Credit Card Rates," Federal Reserve Bank of San Francisco, Weekly Letter (November 29, 1991 ), unpaginated.

17. Credit card banks are so designated by meeting two criteria: (1) the bulk of their assets are loans to individuals (consumer lending) and (2) 90 percent or more of their consumer lending involves credit card or related plans. Large credit card banks are those whose assets exceeded $200 million at the end of 1991. At that time, thirty-one banks were in this category, accounting for 61 percent of all credit card receivables and securitized credit card debt at commercial banks.

18. The basic theory was first developed by George J. Stigler in "The Economics of Information," Journal of Political Economy, vol. 69 (June 1961), pp. 213-25.

19. The implications of information theory underlie enactment of the Credit and Charge Card Disclosure Act of 1988. The act requires issuers of credit cards to disclose, in their solicitations, information about the terms of their credit card plans. The purpose of the act was to promote competition in the credit card market by facilitating credit shopping by consumers.

20. Thomas A. Durkin and Gregory E. Elliehausen, 1977 Consumer Credit Survey (Board of Governors of the Federal Reserve System, 1978) and 1983 and 1989 Surveys of Consumer Finances, sponsored by the Federal Reserve in cooperation with other agencies (data available from the National Technical Information Service).

21. Results of the survey are discussed in A. Charlene Sullivan, "How Disclosure Legislation May Affect Consumer Shopping for Credit Cards," Credit Card Management, vol. 1, no. 4 (September/ October 1988), pp. 86-88; and in Debra Drecnik Worden and Robert M. Fisher, "Perceived Costs and Benefits of Shopping for Credit: The Case of Credit Cards" (unpublished study, Purdue University Credit Research Center, February 1987), pp. 1-14.

22. The survey by Payment Systems, Inc., also found convenience users and revolvers to be equally likely to respond to solicitations for credit cards that charge no annual fee. In addition, convenience users found offers of higher credit limits more attractive than did revolvers. The attraction to higher credit limits probably reflects convenience users' tendency, on average, to charge more than revolvers during a given month. For example, during the month before the 1989 Survey of Consumer Finances, the mean amount charged by convenience users was $524, compared with $334 for revolvers.

23. For additional discussion of the implications of the costs of switching cards, see Paul S. Calem, "The Strange Behavior of the Credit Card Market," Federal Reserve Bank of Philadelphia, Business Review (January/February 1992), pp. 3-14.

24. Julio J. Rotemberg and Garth Saloner, "The Relative Rigidity of Monopoly Pricing," American Economic Review, vol. 77, no. 5 (December 1987), pp. 917-26.

For a discussion of a theory suggesting that imperfect consumer information may lead to interest rate stickiness, see J. Michael Woolley, "Imperfect Information, Adverse Selection and Interest Rate Sluggishness in the Pricing of Bank Credit Cards," Finance and Economics Discussion Series 37 (Board of Governors of the Federal Reserve System, September 1988).

25. The costs of changing rates include costs associated with revising advertising and solicitation materials and notifying cardholders of changes. In addition, regulatory barriers come into play when rates are increased. Federal regulations (Truth-in-Lending) and many state laws have requirements about notification of rate increases, and some states require that cardholders be allowed to pay off existing balances at the old (lower) rate. If lenders adjusted rates downward when funding costs declined, they would have to comply with these regulations whenever a subsequent rise in funding costs made a rate increase seem appropriate. Some states are currently reviewing these regulations.

26. Lawrence M. Ausubel, "The Failure of Competition in the Credit Card Market," American Economic Review, vol. 81, no. 1 (March 1991), pp. 50-81.

27. In February 1992, for example, American Express announced such a three-tiered pricing structure for its Optima card program. Currently, Optima cardholders who have a record of substantial card use and ontime payment are charged the prime rate plus 6.5 percent on revolved balances, and chronic late-payers are charged prime plus 12.25 percent, New cardholders and those not meeting the spending criteria are charged prime plus 8.25 percent. Citicorp began a similar plan in June. Holders of the standard card who qualify pay prime plus 9,4 percent (down from a fixed rate of 19.8 percent), and holders of "preferred cards" who qualify pay prime plus 7.4 percent (down from 16.8 percent). Citicorp estimated that about 9 million of its 21 million cardholders would qualify for the reduced rates.