Do consumers really want credit card reform?

Federal Reserve Bank of Kansas City - Economic Review, Third Quarter 1999 by Combs, Kathryn L, Schreft, Stacey L

Earlier this year, several bills were introduced in Congress to curb what many consumer advocates have described as abusive credit card practices. These bills were intended to keep credit card issuers from penalizing consumers for paying their card balances in full each month. In unveiling one of the measures, Congressman John LaFalce declared, "[Consumers] should not be tricked or trapped into escalating interest rates and unnecessary fees. And they clearly deserve better than to be punished for paying off debt and for responsibly using their credit cards."

Apparently, many consumers agree. According to a November 1996 survey by Money magazine, 79 percent of respondents supported legislation to restrict how credit card issuers set fees and account terms.

With such strong consumer support for credit card reform, it is not surprising that Congress responded. In fact, Congress has repeatedly considered similar measures, some even more restrictive, such as proposals to cap the interest rate charged on credit card accounts. These measures have in common one potentially disturbing feature: if passed into law, they each would impose price controls on credit card accounts.

This article addresses whether such legislative efforts can achieve the stated objective of benefiting consumers. Section I reviews many past and pending efforts to reform credit card pricing. The effects of such price controls depend on the many price terms and product features that determine a credit card's true cost to consumers, and on industry characteristics that determine how card issuers set account terms. Consequently, section II describes the price of a credit card, while section III considers the structure of the card industry and its implications for issuers' pricing practices. Sections IV and V analyze the economic effects of setting a ceiling on one or more components of price. The conclusion is that consumers as a whole generally do not benefit from reform measures of the type studied. The effective price of a credit card account might not fall for many-or any-consumers as a result of a pricing restriction, and credit availability is likely to be reduced, at least to some consumers. Supporting evidence from the U.S. economy's most recent experience with binding price ceilings on consumer credit is presented in section VI. The article concludes in section VII that consumers should think twice before asking for pricing restrictions on credit cards.

THE REVOLVING DOOR OF CREDIT CARD REFORM

The desire for reform of credit card pricing appears to stem from events in 1980. Interest rates reached record levels early that year, which meant that card issuers found their cost of funds rising to record levels as well. State usury ceilings in place at the time capped the interest rate that could be charged on consumer loans. With market interest rates bumping against ceilings in many states, credit card lending became unprofitable. Many states passed emergency legislation to raise the ceilings on interest rates. And the Federal Reserve Board established a national requirement of 30days' advance notice for all changes to the terms of credit card accounts. This requirement superseded the multitude of state regulations regarding cardholder notification, and thus allowed card terms to be changed more quickly and more frequently. Card issuers responded, raising interest rates and adjusting other account terms. (Section VI reviews the 1980 experience in more detail.)

By 1985, market interest rates had fallen dramatically, while credit card rates remained high. The national average for credit card interest rates was reportedly 18.62 percent, while the prime rate was down to 9.5 percent and the discount rate-the rate at which the Federal Reserve lends to banks-was at 7.5 percent. The wide gap in rates caught the attention of consumer groups and policymakers, initiating the first round of many efforts to reform card pricing (U.S. House 1985).

Reform efforts have fallen into two categories: those aimed at forcing issuers to disclose more fully and clearly the terms of the charge accounts they offer and those aimed at restricting issuers' ability to set account prices. Many of the proposals to restrict pricing also incorporate measures to improve disclosure. While the benefits of disclosure measures are themselves debatable, this article addresses only pricing restrictions.

Early reform efforts

In 1985, legislators introduced several bills into Congress that aimed to cap credit card interest rates. (Table 1 summarizes these and other selected legislative efforts.) Each bill set a maximum level for the annual percentage interest rate (APR) that could be charged on a credit card account. The caps were flexible in that they tied the maximum APR to some market interest rate, rather than fixing it at a specific level. Two bills were introduced in the House of Representatives. One limited the APR to five percentage points above the 3-month Treasury bill rate unless a study of competition in the card industry found existing rates to reflect the cost of funds and degree of competition for new card accounts. Bills tying the APR to yet other market rates were introduced into the Senate. Subcommittees held hearings on all measure, but that is where congressional action ended.