Regulation & Credit Card Companies

My wife was going through the mail yesterday and noticed that the contract terms for two of our credit cards were changing.

On the first card there was a large credit-limit increase (unrequested), and on the second, the interest rate for carrying a balance was being adjusted upward to 18%. Neither of these changes were of much consequence: we don’t carry a balance, and, as I said, the credit-limit increase (timed for the holidays, no doubt) was not requested.

I am generally not in favor of increased regulation for private contractual arrangements. Paternalism from politicians is nearly always distasteful and/or ill-advised, and the accompanying over and under-inclusiveness problems make government regulation of private contractual arrangements difficult to do well. Additionally, one person’s license to make irresponsible decisions is another’s much-needed access to credit.

But the credit card industry needs more regulation. An 18% interest rate is unconscionable, and the variety of programs by which credit card companies ensnare unsophisticated borrowers disproportionately impacts the most vulnerable consumers. In her book, The Two-Income Trap, bankruptcy expert and Harvard law professor, Elizabeth Warren, recounts being hired as a consultant by Citibank to recommend ways to cut its losses from cardholders in financial trouble. She made a proposal essentially arguing that Citi should stop lending to borrowers who were already in obvious financial trouble. As she recounts it, the ranking executive present at the meeting replied “We appreciate your presentation. We really do. But we have no interest in cutting back on our lending to these people. They are the ones who provide most of our profits.” Warren is a bit of a polemicist, and she has been known to strain statistics to the breaking point.

Nevertheless, it seems to me that the credit card industry, as presently constructed, is morally bankrupt (not just morally in Citi’s case). It systematically tries to identify and exploit the most vulnerable and unsophisticated members of society by offering temporary financial relief in exchange for an unreasonably large long-term commitment. I plan to explore in a future post the type of regulatory safeguards that I think should be in place, but I am curious in the meantime about people’s thoughts. Are many of the credit card industry’s practices immoral? Does the industry need more regulation? If so, what should that regulation look like?

9 Responses to Regulation & Credit Card Companies

  • Donald R. McClarey says:

    I have small love for the credit card companies, as my hundreds of bankruptcy clients can attest, but you can either have easy credit with little regulation, or you can have tight credit with lots of regulation. Credit card debt is a classic unsecured debt. Those type of debts are going to have high interest rates unless the government subsidizes the loans. Who knows? Perhaps the government will be doing that in a few months. The Federal government is doing precisely the wrong thing with the bailouts, and I imagine this philosophy will spread with the government taking on additional obligations that the taxpayers will never be able to pay. Far better to let debtors, both individual and corporate take bankruptcy.

  • Zak says:

    I am relatively open to regulation, and I hold no love for credit card companies, but capping their interest rates just drives people to pay day lenders and loan sharks, with worse outcomes than bankruptcy.

  • John Henry says:

    Donald,

    I agree that unsecured debt is going to carry a higher interest rate, but it seems to me that it would be relatively easy to cap the interest rate at something like the the prime rate plus 6-8 percent. This would undoubtedly reduce the availability of credit to some borrowers, but many of these borrowers are simply postponing the inevitable. On average, a person who is willing to borrow at an 18% APR for a significant period of time is not in a good position to repay it.

    This would mean that people would probably have to declare bankruptcy earlier, and perhaps on the margin it would force more people into bankruptcy because of the lack of available credit. It seems to me that this might be a better outcome. People would not be able to incur as much debt, which would mean less crushing levels of debts for debtors and less write-offs for financial service companies. It would also protect individuals who are not particularly financially savvy from excessively high interest rates.

    Zak,

    You raise a good point about pay-day lenders. Any reform would have to encompass pay day lenders as well (necessarily with somewhat higher interest rates), so that the situation would not be made worse than it currently is.

  • “but it seems to me that it would be relatively easy to cap the interest rate at something like the the prime rate plus 6-8 percent.”

    It’s certainly very easy to do John Henry by government fiat, but it would also place credit cards out of the hands of most people who believe that they need credit. Today the prime rate is 4.00. Limit credit card rates to 10.00 or 12.00 and only people with pristine credit ratings will be able to have credit cards. Banks are in business to make money and they are not going to give unsecured loans to people with less than stellar credit histories without the ability to charge interest rates commensurate with the risk. I believe adults should be able to decide for themselves whether an interest rate on a credit card is too high. Careful buyers with good credit ratings can get low interest credit cards. For the rest, let them make the decision as to what is in their economic interest rather than have the government take that decision from them. The vast majority of credit card debt is repaid so I would submit that only a small minority of credit card holders are unable or unwilling to live up to the terms of their agreements. I prefer a society with easy credit and high interest rates on unsecured debt to government regulation which artificially lowers interest rates and dries up credit.

  • On average, a person who is willing to borrow at an 18% APR for a significant period of time is not in a good position to repay it.

    Generally speaking, an interest rate will reflect convenience (both convenience of the borrower and potential inconvenience for the lender) as part of the interest rate. One of the things about credit cards is that they allow you to take out a significant loan (up to a certain amount) at any time, and pay it back whenever you want, so long as you’re making a pretty minimal payment. That naturally increases the interest rate — both because the lender doesn’t know when they’ll get their money back, and because the borrower can take out money based on circumstances that he knows about but the lender doesn’t.

    So for instance, if I lost my job, and then we had a major medical expense, I could run up a few thousand dollars on my credit card without any clear idea of how I’d pay it, using it as a way to get a 5k loan without collateral or any fixed pay-off period and wait till I had work again — but if the lender had to evaluate me at that moment they would certainly not offer to give me 5k given that I had no income.

    In other words, it give the borrower the edge in terms of information.

    Now, I agree that credit card companies are often, to some extent, predatory in their approach. They know that if they have good enough ways of calculating who really needs money but will eventually pay it all of, they can successfully land long term borrowers who will net them a lot of interest.

    However, that the CC companies even make much money in the first place suggests that much of the time they do indeed get paid off — which means that most borrowers aren’t simply postponing the inevitable. (While nearly everyone who declares bankruptcy doubtless has lots of CC debt, most people with CC debt never declare bankruptcy.)

    I suppose a lot depends on what you mean by “significant period”. We’ve had a pair of nearly year long periods in our marriage when a combination of unexpected expenses and low income resulted in carrying a balance — though for a slightly lower interest rate.

    The trick is, I was fairly confident in my ability to earn and save my way out of those situations — but a government regulator is not really in a good position to determine if a given borrower is.

  • John Henry says:

    Donald,

    “I prefer a society with easy credit and high interest rates on unsecured debt to government regulation which artificially lowers interest rates and dries up credit.”

    As I said there is a trade-off here. I guess my problem is that credit card companies frequently (still more, pay-day loan companies) engage in predatory lending tactics that increase profitability but harm financially unsophisticated individuals. I think this is immoral in some cases, although I am not going to grab a pitchfork and start chanting ‘usury! usury!’. Just because something is immoral does not mean it should be illegal, and usum non tollit abusus.

    Nevertheless, I would be interested in looking at ways to curb the more questionable practices. As you note, this is a paternalistic approach that would constrict individual parties’ freedom to contract. I have not conducted the type of empirical studies that would be necessary to identify the best ways to change the existing law (the 6%-8% plus prime figure was intended as an example rather than a proposal). In any system there will be individuals who make irresponsible decisions with their freedom, as well as some level of regulation to protect consumers. The question is: have we struck the best balance between freedom of contract and regulation? I am not sure that we have, and I can think of explanations for that state of affairs (credit card companies likely are more effective lobbyists), but I am open to being persuaded otherwise.

  • John Henry says:

    Darwin,

    “In other words, it gives the borrower the edge in terms of information…but a government regulator is not really in a good position to determine if a given borrower is (likely to be able to pay back the money).”

    A well-thought out response (as was Donald’s). I agree, of course, that the government is not in a good position to determine if an individual borrower would be best served by additional debt. At the same time, it seems to me that there is often an information asymmetry between borrowers and credit card companies. For instance, a credit card company can increase the interest rate rather suddenly on a borrower – and borrower’s often do not consider this ex ante. In the article cited below, an individual missed one payment and immediately their interest rate increased from 9% to 30%.

    That individual was able to pay off the balance and immediately did, but those types of practices are not uncommon, and not everyone can pay off the balance that quickly. The incentive structure for credit card companies is to push people just to the verge of bankruptcy with higher interest rates, before working out a payment plan at a lower rate (e.g. somewhere between 9% and 30%). And, of course, it is the least sophisticated borrowers who are disproportionately impacted. It is fair to respond to all this that the inability of some people to manage their finances should not deprive the sensible majority of a very useful financial planning tool. I am not proposing that we do away with credit card companies; simply suggesting that this is an area (and there aren’t many) where I might support more regulation. Although I wasn’t aware of this when I wrote the post, it appears that the Federal Reserve and Congress are considering additional regulations that would take effect next year (in fact, if the article is correct, that may be one of the reasons why the interest rate for carrying a balance on our card is being raised now). It seems to me that there is a real difference in information between borrowers and credit card companies, that credit card companies often have greater bargaining power after the initial transactions, and that credit card companies are a sophisticated party with an incentive to encourage people to make unwise financial decisions. In such cases, I am more sympathetic to a higher level of regulatory oversight. In any case, it will be interesting to see what happens next year.

    http://www.businessweek.com/magazine/content/08_42/b4104024799703_page_2.htm

  • And similarly, I’m not necessarily totally against regulation of such companies per se — but it strikes me that most of the regulation ideas which are developed specifically by those wanting to “protect the poor from predatory lending” aren’t unhelpful. Maybe in part because those with that specific aim often attempt too much.

    I could potentially see things which are fairly circumscribed working well — designed more to change the weighting of the game rather than “protect” people. For instance, one might allow rate changes at most once a year and limit the amount a rate could be increased as a “penalty rate”. (Though one would need to understand this would result in higher rates over all and weigh the two possibilities.)

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