Bryan Caplan  

Exactly Wrong: The Real Unintended Consequences of New Credit Card Regs

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Here's a bizarre set of predictions about the effect of new credit card regs:
...Congress is moving to limit the penalties on riskier borrowers, who have become a prime source of billions of dollars in fee revenue for the industry. And to make up for lost income, the card companies are going after those people with sterling credit.

Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.

"It will be a different business," said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation's biggest banks. "Those that manage their credit well will in some degree subsidize those that have credit problems."

Wrong, wrong, wrong.  When you make lending to high-risk people less attractive, the result is not worse terms for low-risk people who have been profitable all along.  The result is that high-risk people get less credit.  They used to be able to get credit despite their credit-unworthiness by paying extra; if the law forbids this, why lend to them?

This article is as crazy as a story about the minimum wage claiming that highly-skilled workers suffer the most because employers need to "make up the difference somewhere."  The correct retort, of course, is "Yea, they make up the difference by buying less of the labor that now costs more."

But who am I to question the wisdom of leading members of the credit card industry?  The answer, I strongly suspect, is that the industry leaders don't believe their own argument.  They're demagoging.  The sensible objection that, "Credit card regs that protect high-risk consumers will make it harder for them to get credit," is almost impossible to sell.  The ridiculous objection that, "Low-risk consumers will pay the price," is, alas, a far easier sell.


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CATEGORIES: Regulation
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TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/1866
The author at Roth & Company, P.C. in a related article titled Senate approves unintended consequences, 90-5 writes:
    The financial supergeniuses in the U.S. Senate have voted to make it harder to get credit. Here's what the politicians... [Tracked on May 20, 2009 11:01 AM]
COMMENTS (20 to date)
Matt C. writes:

I am sorry, but I must disagree. Low risk users are getting screwed in addition to the loss of higher risk individuals losing out on credit. If you have received a letter recently from your credit card company saying you are losing your fixed intrest rate and it is becoming variable. It's because in 2010 cc companies can no longer price the cc's based on risk. You can google UDAP and pull up the changes in the regulations. But at the same time they can't deny higher risk individuals. CC companies have to keep careful tabs on why they denied individuals, otherwise they could get in trouble for denying someone for "no good" reason.

We had a fixed rate card at 7.99% which is now sitting at prime plus 9.6 something....

The Blue Jay writes:

I have a brother who works for a major credit card company. I asked him about the regs yesterday, and he told me they simply plan on doing just as you say: they'll no longer offer money to people who are risky borrowers. Those interest rates were so high because that's the rate they had to charge in order to make money. He awaits the next step: government mandate to supply credit to risky borrowers at some determined rate.

tjames writes:

That seems like non-sense. I'd expect that the credit card companies, as profit-maximizing enterprises, would already be charging low-risk consumers the optimal amount for the credit they issue. If they could arbitrarily jack up their profits on these folks, doesn't it follow that they already would have done so?

I expect they will continue to treat me - a low risk individual - just as they always have, which is to say they will get everything out of me they can without losing my business to a competitor.

Low risk individuals may often use credit cards purely as a convenience, or for the kickbacks. As soon as the convenience gets to be too expensive, we can simply revert to debit cards, or actual cash.

I have to agree - the article makes no sense.

Dan Weber writes:

I'm so glad you're saying this, Bryan. Everyone seems to just be swallowing this fear-mongering the credit-card industry is spewing.

The card industry will do what it can, and I'm not saying that the new regs are right or wrong. But they won't try these tricks with me unless they want to lose all their business.

John Thacker writes:

I disagree with you Bryan. The claim does make some sense. Credit card companies are restricted by law from treating high and low risk customers that differently once they give them a card, at least on the basis of risk alone. (They're allowed to jack up rates for anyone if they miss a payment, though.) They can deny cards to high risk applicants; however they really have to justify that to regulators as well.

Since they are not able to treat high and low risk consumers as differently as they might like, credit card companies use the cash back/rewards/no annual fee incentives to gets more applicants. They realize that they'll get some relatively unprofitable low risk consumers, but the more profitable higher risk consumers subsidize that.

When they're forced to give up their more profitable customers, the rewards become less profitable, because they don't bring in enough customers who pay more in fees and interest than they get in rewards.

There have been separate cases of card companies dropping low risk consumers from cards because those consumers didn't incur fees or interest, and thus weren't profitable.

John Thacker writes:

Your claim would be more true in the absence of regulation. Regulation is not quite as pervasive as "community rating" of insurance is in NY and NJ, but it has a real effect on the market.

John Thacker writes:

Interchange fees run, IIRC, around 2-3%. You can easily get maximum rewards cards that reward you more than that.

Of course, that could just have been a mistake on the credit card company's fault, and they'd be reducing those awards even without legislation.

John Thacker writes:

It doesn't require low risk customers to be unprofitable, mind you. It only requires that high risk customers are currently more profitable, and that the behavioral response of high risk customers makes "tricking them" into going for cards with high rewards but high penalties for missed payments profitable.

Many of the cards with the highest reward offerings have the worst penalties if you miss a payment or carry a balance.

jb writes:

Thanks for this. I kept reading that statement (it is showing up everywhere) and kept thinking - "most people with good credit don't have to use a credit card - they use it because of convenience. How can they possibly get more money out of us (low risk folks), who can choose to use debit cards or checks?"


Joel writes:

The one thing you don't say is: will cutting off high risk borrowers be good or bad?

The country is awash in a sea of debt to pay for ordinary operating expenses. (Cf. State of California). Maybe the reason these borrowers are squealing is that they borrowed money that they can't afford to pay back. If they can't afford to pay, maybe they shouldn't borrow it, and then they won’t have unpayable debts and the banks will have fewer defaults.

I realize that less debt will reduce the velocity of money and continue the contraction of consumer spending, but perhaps fewer people will get into financial trouble and eventually learn to live within their means.

tom writes:

Everyone in this thread is assuming that the federal government will allow big credit card companies to decide not to lend to high-risk borrowers. This is a weirdly naive assumption given our recent history.

In a few months, we will have a federal agency watching all credit card providers to make sure that they do not respond to these new regulations in a way that has an adverse impact on disadvantaged groups. Why isn't that obvious to you?

Boonton writes:

tjames

That seems like non-sense. I'd expect that the credit card companies, as profit-maximizing enterprises, would already be charging low-risk consumers the optimal amount for the credit they issue.

So we are back to assuming the major financial institutions are efficient at pricing risk correctly? Well, what did that take not even a full 6 months since the last time we learned the world was going to blow up because risk was estimated to be less risky than it really was.

Joel
The one thing you don't say is: will cutting off high risk borrowers be good or bad?

This I think is a very important question. In an idealized rational market it would be bad. High risk people know they are high risk and will accept the prevailing price for credit and use it rationally. Reality has demonstrated, I think, that just as lenders are easily subject to being too optimistic so are borrowers. While I'm sure its possible for high risk borrowers to make rational use of credit (even though the cost to them is high), I think the more common story is roping in high risk borrowers by feeding their delusions and reinforcing destructive habits. Is this a paternalistic stance? Yes it is.

tom
Everyone in this thread is assuming that the federal government will allow big credit card companies to decide not to lend to high-risk borrowers. This is a weirdly naive assumption given our recent history.

There's no real law or regulation requiring credit card companies to lend. They can cut you off just about whenever they want no questions asked. See the stories about Amex and other cards cancelling people because they were buying used tires or shopping at stores that seemed 'poor'. If their datamining smells like you may be getting ready to max out your cards to extend some unsustainable financial position they have few hurdles stopping them from striking you first. Yes they can't blatently discriminate based on race or gender, but when was the last time you saw a credit card application that asked for your race?

I would expect the reaction to be not even less credit so much for the marginal borrower but actually less aggressive marketing to the marginal borrower. All things being equal I suspect that might be a somewhat good thing. The hypothetically rational 'high risk' borrower I spoke about before will still almost certainly be able to find credit if he is engaging on a campaign to rebuild his score or something similiar.

tom writes:

Boonton, I think you and the others in the thread, including Bryan, are making a naive assumption: "Obama must not realize that if you prohibit lenders from charging high interest rates for poor credits, the lenders will just stop lending to poor credits."

I believe that Obama and his team know this standard pro-usury argument already, and I bet that they know it is how lenders will want to react. If so, then there are only two possibilities: (1) the Administration WANTS lenders to stop lending to poor credits or (2) it believes it can use regulation and intimidation to force the lenders to treat bad credits as if they were good. (1) is possible, but I lean strongly toward (2).

aaron writes:

Ummm. As a low risk borrower, if I'm charged much more than nothing, I won't borrow.

aaron writes:

I think mostly it will make credit card companies realized the risks they are already taking on.

david writes:

I thought the low risk borrowers weren't really all that profitable. I've got two credit cards, pay them back in full every billing cycle and don't think I've paid the credit card companies a dime.

tom writes:

david, providers make a lot of money on consumer interest and fees. But they also make money on merchant fees, maybe 2% of each charge, depending on the deal. I think that's why in some parts of California it's so hard to find a gas station that takes credit cards.

Boonton writes:

Boonton, I think you and the others in the thread, including Bryan, are making a naive assumption: "Obama must not realize that if you prohibit lenders from charging high interest rates for poor credits, the lenders will just stop lending to poor credits."

Actually unless I'm mistaken the proposal doesn't prevent lenders from charging high rates or fees, they just have to be upfront about it. No slipping them in under cover of boilerplate or sudden 're-evaluations'.

(1) the Administration WANTS lenders to stop lending to poor credits or (2) it believes it can use regulation and intimidation to force the lenders to treat bad credits as if they were good. (1) is possible, but I lean strongly toward (2).

Poor credit != poor. There are poor people with good credit and wealthy people with horrible credit (see for example the recent article by the NY Times writer whose near foreclosure despite having an income over $100K a year). I really doubt Obama or his team wants to simply force poor credit scores, regardless of income, to be treated as good. No evidence has yet been presented to that effect.

Regardless, this argument is pointless. It's structure is of the form of "If Obama gets X, he will do Y". Assuming Y is something bad, that says nothing about the merits of X. If you show me Obama trying to do Y, I'll oppose him on that. If you can't, well you're kind of wasting time.

aaron
Ummm. As a low risk borrower, if I'm charged much more than nothing, I won't borrow.

A good summary of the original point. I would just add "Or I will go to someone else who won't charge me much more than nothing and since I'm low risk I will find someone!"

david
I thought the low risk borrowers weren't really all that profitable.

Quite possibly true but there's a world of difference between that and a low risk borrower resulting in a loss!

Jeremy, Alabama writes:

Bryan, bless him, is thinking economically. He should be thinking politically.

What Bryan says will happen for a year or two. Then the NYT or other sob-story MSM will carry a piece on how the nasty cc companies are "unfairly targeting the poor for high fees and rates". Then Barney Frank and Obama get involved. What happens after this I leave as a (not very complicated) exercise for the reader.

Boonton writes:

I'll say it again 'poor credit' != 'poor'

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