Statement submitted by the Board of Governors of the Federal Reserve System to the Subcommittee on Consumer Credit and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, February 9, 1994 - Transcript

Federal Reserve Bulletin, April, 1994

Statement submitted by the Board of Governors of the Federal Reserve System to the Subcommittee on Consumer Credit and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, February 9, 1994.

The Board of Governors of the Federal Reserve System appreciates the opportunity to comment on the credit and charge card legislation being considered in H.R.1842 and H.R.2175. Because this legislation is driven, in part, by concerns about the level of credit card rates, we thought it would be useful to the subcommittee to have some current background on this issue.

RECENT DEVELOPMENTS IN CREDIT CARD PRICING

Credit card lending is a competitive market that consists of many thousands of card issuers, all free to establish their own prices and other lending terms. The credit card market has changed significantly over the past few years. Competition, which was keen during the 1980s, has grown more intense as new firms have entered the market and challenged established card issuers by aggressively pricing their credit card products. While competition in the 1980s focused on efforts to broaden customer bases by increasing the availability of cards to higher risk groups and by offering additional product enhancements, this focus has shifted to efforts to retain and broaden customer bases by offering more favorable interest rates, waivers of annual fees, and, in some larger programs, rebates of various types.

To better understand credit card pricing behavior, it is useful to compare credit card lending with other types of bank loans. Generally, credit card lending is riskier than other types of bank lending because it is unsecured and card holders may choose to use their cards when they are under the most financial distress. Consequently, a relatively large "risk premium" is built into the pricing structure of credit card plans. A second prominent feature of credit card lending is that the cost of funds, while an important component of total costs, makes up a relatively small percentage of total lending costs compared with other types of bank lending. Because funding costs are a smaller component of total costs for credit card lending, changes in the cost of funds are more likely to be offset by movements in other cost components. A third major factor that differentiates credit card lending from other types of bank lending is that the interest earned on credit card balances is substantially less than the stated rate might suggest because convenience users (those who pay their balances in full each month) generate little or no revenue from finance charges.

After many years of relative stability, credit card interest rates recently have fallen sharply. An unusually steep and sustained decline in the cost of funds to issuers and the lingering effects of the last recession, which saw outstanding balances on credit cards grow at a much reduced pace, have exerted downward pressure on credit card interest rates. In addition, the elevated default rates and substantial credit losses stemming from the past recession appear to have fundamentally influenced the pricing behavior of many card issuers, including a number of the largest issuers in the country. Although credit card issuers in the past tended to offer a basic plan with one rate for all customers regardless of risk and account activity level, some of the largest issuers have now lowered rates for card holders who have good payment records and charge large amounts. Higher interest rates are still applied, however, to higher-risk customers: those who have a record of not paying their bills on time.

Contributing to the growing interest rate competition may be an increasing sensitivity by consumers to credit card rates, perhaps because of the difficult times that many encountered during the last recession and the heightened publicity about the high rates of interest on credit cards. Another factor that may be causing a decrease in credit card rates is the increased difficulty card issuers have encountered in acquiring new customers in a relatively mature market. The high cost of attracting new customers in a competitive, mature market places a premium on retaining existing customers, particularly on those who charge large volumes and revolve substantial balances. Reducing rates and waiving annual fees is one way to curtail attrition. A further indication of growing interest rate competition is the aggressive marketing of rollover balance programs that offer attractive rates to card holders who roll their outstanding debt into a new card issuer's plan.

Evidence of the changing nature of competition in the credit card market can be found in the Federal Reserve's series on credit card interest rates published in its G. 19 statistical release. This data series shows the average rate charged by a sample of credit card issuers for their largest credit card plans. From the end of 1981 through the beginning of 1991 this average credit card interest rate varied only a little and averaged more than 18 percent. Beginning in early 1991, however, it began a steady decline that has continued to date. In February 1991, the average interest rate on credit cards as measured by our survey was 18.28 percent. Our latest survey, for November 1993, indicates the average rate had fallen to 16.30 percent.