Earlier this week, I received Sam Waltz’s column for this week, which coincidentally covers the same topic that I had decided to tackle.
Sen. Bernie Sanders (I-Vt.) and Rep. Alexandria Ocasio-Cortez (D-N.Y.) have proposed a 15 percent credit-card interest cap that essentially reverses a 1978 Supreme Court decision that gutted state usury laws and led to the creation of Delaware’s Financial Center Development Act, which fueled the growth of MBNA, First USA, and other credit card issuers. (For full disclosure, I worked for MBNA and Bank of America for nearly 20 years).
I think Sam and I arrived at basically the same place — not a good law in general or for Delaware specifically — but I think we arrive there on different paths. I hope you’ll indulge me in walking you down my path.
The title of the bill — the Loan Shark Prevention Act — tells you all you need to know about Sanders and AOC’s views of banks. They seem to assume that whatever is bad for the banks will be good for consumers, which is rarely true.
What’s happening here is that Bernie and AOC are inserting themselves into a market that is fairly competitive and threatening to make it arguably less so.
To be clear, making credit more affordable for Americans at a time when they carry a collective balance of $870 billion, with an average credit-card APR approaching 18%, is not an unreasonable goal. But the unintended consequences of this approach would be to remove access to credit for millions of low- and moderate-income households.
Ocasio-Cortez and Sanders rail against banks that charge double-digit interest while they borrow funds at 2.5% (the rate at which banks lend to each other).
But that’s not how it works. That 2.5% rate is what banks pay on short-term, low-risk borrowing, which is cheaper than longer-term consumer credit.
Credit-card issuers are offering rates online as low as 8.5% for a variable-rate credit card and higher APR cards that vary based on terms, credit limits, rewards programs and the applicant’s credit history.
This proposal doesn’t address the various levers that banks use to control the risk that customers won’t pay them back. As Sam notes, banks have done a decent job of defending and explaining risk-based repricing over the years. But what will happen should this bill get some traction?
Most cards provide 30 days of free credit if the statement is paid on time, a feature that might disappear, along with rewards programs, if interest rate caps were created.
When caps are imposed and market rates are rising, lenders will simply adjust their customer eligibility profile to align to the interest rates that can be charged.
As a result, the bottom tier of borrowers will lose access to credit. Since the passage of the CARD Act in 2009, which regulated many aspects of credit card terms and rates, but did not impose interest-rate caps, millions of subprime cardholders were pushed out of the credit-card market.
When the Durbin Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act went into effect in 2010, debit-card rewards all but ceased to exist. The amendment capped the interchange fees debit-card issuers could charge to retailers. Banks had used the revenue from those fees to finance the debit rewards programs — so when that well ran dry, the programs were terminated.
What they’re doing is essentially substituting a federal usury law for the existing state ones using a template designed for credit unions that can deal with a cap (which incidentally is 18% for the credit unions, not 15%) because they don’t pay federal income tax, a government subsidy that enables them to charge lower interest rates.
For big banks, the credit-card business is indeed more profitable than others; yet much of the large spread between their cost of funds and interest rates they charge reflects overhead, including such costs as managing billions of transactions and covering unsecured losses. Meanwhile, only 2.5% of customers are delinquent on their cards, well below historical rates.
This suggests that many people are using their credit cards responsibly, as a way of smoothing out the bumps in their economic lives. Restricting interest rates could cause credit card companies and banks to pull back on this sort of lending. Instead of cutting people off from credit cards, perhaps banks should spend more time addressing onerous health-care bills, skyrocketing tuition bills and stagnant wages.
Interest-rate caps have rarely ever worked. In a competitive system, interest rates reflect a variety of financial factors, including credit history, customer defaults, transaction size, credit limits, rewards programs, collection proceedings and fraud. Median credit-card rates also tend to obscure the real facts.
Retailers may need to curtail their store credit-card offerings with an average interest rate of nearly 30%. Interest rates on these cards are higher generally because stores offer the cards on the spot without doing any underwriting to guarantee a consumer’s ability to repay their debt. As a result, they’re fairly unpopular with consumers, which is evidence that the market works. But these cards can help consumers build up their credit history, especially if they avoid the high interest rates by paying their balance in full each month.
The financial industry is one of America’s most regulated sectors, with more than 27,000 new regulations since 2010. It explains in some ways why, despite the bill’s sponsors’ claims to the contrary about greedy banks as loan sharks, recent returns on equity remain comparably low, particularly for the smallest banks.
Perhaps a better approach would be setting a higher interest rate cap (perhaps something in 25% range) and allow it to fluctuate based on market interest rates. That would have the preferable effect of hurting the lenders who exploit consumers while allowing most Americans to borrow when needed.