Barry Nalebuff and I have a new column in Forbes (“A Market Test for Credit Cards”) which criticizes some aspects of the recent credit-card legislation as being too anti-market.
We’re troubled by the absolute ban on interest-rate hikes on existing balances unless the card-holder falls 60 days behind on the minimum payments. If the risk of default increases because the borrower stops paying on other loans or runs up balances on other credit cards, the law should at least give issuers and cardholders the option of setting up a relationship where the interest rate would increase with the risk of default.
The problem is that many rate hikes have not been driven by changes in the risk of default.
Unfortunately, banks have a history of raising rates just because they can. It isn’t reasonable to change the terms to take advantage of asleep-at-the-wheel cardholders who miss notices in the midst of their junk mail.
The challenge is to try to create a regulatory system that allows risk-related increases while discouraging asleep-at-the-wheel advantage taking. It is often efficient to be asleep. I don’t want to live in a world where I have to carefully read all my junk mail.
Barry and I have hit on a solution which basically tries to harness the market to tell us whether a proposed interest-rate hike is reasonable:
At the time when the lender proposes a unilateral change, it would be required to put the existing account balance up for auction on a LendingTree-like service that would allow other credit card issuers to bid for a chance to issue a new card and take over the existing balance.
To identify a clear winner, the government would have to promulgate standardized terms for key non-interest attributes — such as late fees. Credit card companies would only be required to use these terms if they wanted to participate in the auction.
Borrowers wouldn’t be forced to switch to the auction winner. They’d just be given the option. When an existing credit card issuer proposes a rate increase, it would be required to pass on the terms of the winning bid and a comparison with its own terms, and the borrower would decide whether he wanted to make the switch.
A market test would distinguish between good and bad interest hikes. Issuers would not be deterred from making interest increases that were driven by increased risk because they would not be concerned that competitors would undercut their offers. But unfavorable changes in interest rates or late fees that were just trying to squeeze out higher profit might be deterred. The issuer would have to worry that a competitor would steal the business.
Many account holders will still be asleep at the wheel, and others will want to stick with their existing card because they like the reward program or don’t want the hassle of updating credit card numbers on all the automated bill payments they’ve set up online. But the risk that others would read the fine print and defect would have a strong disciplining effect on gougers.
This credit card market test is similar to what the law does in other circumstances when it doesn’t trust the results of arms-lengths negotiations. When a creditor seizes secured property, it must auction the property (rather than merely sell it to a friend at cheap price). When a corporate takeover becomes inevitable, the board of the target corporation (which might be worried about keeping its job), in Delaware under the Revlon rule, has a duty to act as would “auctioneers charged with getting the best price for the stock-holders at a sale of the company.” Asking credit card companies to auction before they hike rates follows this tradition, but it is less radical because it gives the card-holders the option of whether to accept the winner’s offer.
Sometimes the answer to a failure of competition is to require more competition.
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There are some confounding factors. There is a personal cost associated with the effort of switching credit card companies. Furthermore, the consumer has a more realistic estimate of the risk of default than the lender- the consumer can even choose to default. A consumer who knows they are likely to default will not choose to switch companies so as not to incure that additional personal cost. (Note that the additional interest rate that results is also less of a penalty to someone who is likely to default anyway. ) Hence there is less risk to the companies bidding than to the original company since anyone who accepts their offer is less likely to default. The result is to provide a disincentive for raising interest rates above and beyond what a simple economic analysis would suggest.
“It is often efficient to be asleep. I don’t want to live in a world where I have to carefully read all my junk mail.”
Yet this proposed solution creates just this world: you have to read all your junk mail looking for credit card auctions. So no benefit to me as the customer over the previous situation.
Did this solution, and motivations for the credit card issuer, already effectively exist? If interest rates went up too high, the customer could do a balance transfer to a competing credit card company with better rates.
This would also require a change in the FICO scoring system: it’s said that overly frequent credit card churning damages a person’s FICO score. The unintended consequences of the proposed solution is to damage the diligent customer’s FICO score.
So I see no value in this proposal, only greater inefficiencies by adding a new auction bureaucracy to the system with additional junk mail notifying me of auction and offers, beyond the current junk and offers. And it does nothing to enable the customer to remain “asleep at the wheel”.
Basically what you’re asking for is for the gov’t and courts to force competition via regulation because the “free market” doesn’t result in actual competition.
Makes sense to me, and forced competition is a good form of regulation I think.
Shouldn’t the penalty simply be that interest accues and compounds and a non-payment report drives up the interest rate for additional credit?
Increasing the rate only increases the risk of default.
Occasionally the government has to step in when businesses can’t figure it out themselves. Advanta recently closed all of their business customers card accounts (including mine) with about five days notice. Fortunately for me, I have good credit and it was not a hardship to get a new card. I have read that many other business owners had to layoff employees or shut down because they were using their credit cards to finance their businesses. Wouldn’t a notice period of 30 days be a reasonable requirement for a credit card company to implement to prevent such hardships in the future?
Agree entirely with #10. This will do nothing for cardholders who are indeed asleep, and those who aren’t already have the option of a balance transfer.
Also, regarding the following paragraph:
“To identify a clear winner, the government would have to promulgate standardized terms for key non-interest attributes — such as late fees. Credit card companies would only be required to use these terms if they wanted to participate in the auction.”
This strikes me as a strong negative. A wealth of options exists for a reason: there are different types of people with different types of spending habits. (For example, since I generally pay off my balance in full every month, it is important for me to have no annual fee, but I am comfortable with a higher interest rate. Someone who carries a balance might have the opposite incentive. Someone who travels more than I might be willing to trade fees/interest for airline-mile perks, etc.). Restricting this choice doesn’t help the consumer.
While I am generally in favor of market-based solutions, this seems like a bad idea. Two points:
1. The article points out that some users will want to stick with the existing card because they don’t want to go through the hassle of re-setting up automatic payments. Don’t underestimate the pain involved in doing this. This inefficiency, combined with the “sleep at the wheel” customers will allow credit cards issuers to raise rates above the competitive rate.
2. Credit card issuers need to estimate risks at time of card issuance. As long as you keep current, car loans and home mortgage loans don’t change rates if your credit risk increases. Caveat lender.