Sunday, May 24, 2009

Empty threats by credit card companies

Michelle Singletary is usually spot on in her analyses of consumer finance issues. But today's "Color of Money" column on possible responses by credit card companies to new consumer protection measures misses the mark.

Singletary writes
Credit card users who crow that they're seldom charged interest on purchases because they pay their bills on time may not be able to crow much longer. President Obama is about to sign into law new restrictions on the credit card industry that lenders say may lead to the return of widespread annual fees.
I wouldn't be too sure.

Singletary seems to accept the basic industry arguments that one group of card-holders subsidizes another and that the new restrictions will force companies to raise fees on cardholders who use credit responsibly. She quotes industry spokesperson Edward Yingling
"Those who have managed their credit well and currently have very good credit card deals will find that card companies are limited in their ability to distinguish between them and those that have credit problems," Edward L. Yingling, president and chief executive of the American Bankers Association, said in a brief written statement after the legislation passed. "The result will be some subsidy from those that manage their credit well to those that have problems, affecting negatively the terms the former will receive."

Yingling added that the "new rules will limit the ability of card companies to price according to risk."
Singletary goes on to dismiss, correctly, the argument that companies won't be able to identify or discriminate among different levels of risk, but she allows the cross-subsidization argument to stand.

Responsible card users are profitable for card companies. Those users might not often rack up large interest charges and penalties, but the companies are still able to make money on the fees they charge retailers for each purchase, about 2 percent of the value of each transaction.

Also, even responsible customers sometimes miss payments or run into problems that keep them from paying off their full monthly balances. By extending credit, card companies are effectively buying an option on the probability of a payment stumble.

Finally, if the current arrangements with responsible card holders were really so costly to the card companies (at least costly enough to require subsidization), why would they extend credit to such customers at all? The profit-maximizing behavior would seem to be to extend credit only to people who are likely to run balances and to cut other people off. Companies can and do discriminate. From their behavior, we know they aren't charities.

The bottom line is that the extra revenue that companies have received from abusing their high-risk customers have gone into company profits, not into subsidies for other types of customers. The new rules are likely to reduce some of those profits (that is, to the extent that companies don't find new "gotcha" fees to replace the old ones). However, the rules are not likely to raise rates or fees for responsible card holders. To think that they would is to think that the companies were already cutting their responsible customers a break.


Anonymous said...

Dave, I agree that the cross-subsidization argument is silly. Also, network externalities alone suggest that cc companies should want my business (as long as said externalities are greater than the cost of mailing me a bill every month & processing the payment).

As for the "risky" customers, the cc companies face a tradeoff. If they cannot charge these customers enough to cover their costs, they won't extend credit at all. In the presence of network externalities the bar for extending credit is lower than it would have been otherwise. But if these customers' fees (and induced externalities) do not cover their cost, is it possible that the whole cc business will unravel? Might we expect cc companies to go out of business, possibly resulting in fewer competitors?

Pino said...


You mention that the new rules are likely to reduce profits. Is it your position that the banks will be okay with that situation or will they try to re-establish the pre-rule margin?

And if they go after that pre-rule margin, how will they do that?

Dave Ribar said...


That's the risk generally with regulating sub-prime lenders, you might take away credit from people who could really use it.

The card companies will still have many arrows in their quivers, including the ability to set interest rates where they want them. What's being eliminated are "gotcha" fees and other abusive practices.

It's doubtful that any of the companies will go out of business because of the rules.