Developments in the pricing of credit card services

Federal Reserve Bulletin, Sept, 1992 by Glenn B. Canner, Charles A. Luckett, Wayne C. Cook, Mark A. Peirce

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)