When Credit Card Companies Compete, You Win

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.


charles

Spot on...another clever idea. Nice work.

Joshua

I think it is absolutely wrong for a credit card company to increase interest rates on existing balances. Let me tell my situation. I paid for part of medical school by taking out a large cash advance from a credit card of $22,000. I paid 3% up front and will be paying 3.99% until the balance is paid off. I did this instead of taking out a government loan for 6.8%. If they can raise that 3.99% to even 4.99%, any benefit from the deal is gone.

Now if I ran a credit card company and could increase rates on existing balance, I would make offers to everybody for 1.99% for the life of a balance and charge 4% cash advance fee upfront. Then, I'd jack up the rate within 1 year to at least 5.99%, never have charged a rate less than this with the initial cash advance fee included.

Increasing interest rates on existing balances means changing the terms of a contract after the fact, and I think that is unfair.

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Jerry Tsai

Fantastic idea. Kudos.

Jim

I don't worry about missing a payment because a bill gets lost in the junk mail. I'm set up for auto pay. I've done if for years, and I haven't had any issues with it.

Often, auto pay has the option to pay in full or the minimum payment. At least automate the minimum payment to stay out of the deadbeat category and eliminate late fees.

Here's another possible identification technique. It's called the leaky bucket algorithm. It's used to identify chronic offenders from accidental ones. Offenses are given points, which accumulate. The greater the offense is, the more the points on receives. A fixed number of points are removed on a regular basis – say annually. When the number of points accumulated crosses a threshold, then the offender is chronic. Points for an occasional offense will eventually be removed before their accumulation reaches the threshold.

This technique can be used to identify faulty equipment in network hardware from the occasional blip.

It's also the same technique used to identify unsafe drivers on the road. If you only get the occasional speeding ticket, and you can still drive as long as you pay the fine. If you get too many tickets in a fixed period of time, then you'll lose your license.

The same technique could be applied to credit card payments as well.

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NotASycophant

Yeah, the free market laissez faire "invisible hand" economics has worked so well. We definitely need to just let the banks monitor themselves.

keith

What if no other issuer wants to participate in the auction? (perhaps original holder hired lousy risk-management actuaries or the current rate is the result of an unsustainable loss-leader) Can the original holder unilaterally raise their terms to the lowest market-based rate for the account?

econobiker

#2 Joshua wrote: "Increasing interest rates on existing balances means changing the terms of a contract after the fact, and I think that is unfair."

The sad thing is that the credit card industry is entirely based on them being able to change the contract after the fact and just considering "your continued use of the card" as acceptance of mouse sized printed changes in terms and conditions.

If you want to refuse their changes in "terms and conditions" (ie: sweet way to say CONTRACT) you have to snail mail a paper letter to some obscure address in Utah with specific info on the letter for the company not to change the contract. And you better certify, register and return receipt the letter as I am sure they would find it very easy to "have lost"any non registered correspondance in the future.

This industry also limits the consumer's ability to propose changes in the contracts via the contracts themselves.

Mr. Ayers has some neat ideas but the mega-sized corporate banks and card issuers would fight this much harder than they fought to get the bankruptcy laws changed to favor corporations over consumers. It might be easier to roll the anti-usuary laws back to pre-1978 than to do what he proposes...

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AS

Credit card interest rates should only be allowed to be increased for future credit not past credit until the 60 day default. Further, imposition of a late fee should not be allowed to then result in an overbalance fee. Penalties and fees should also not be subject to interest.

If i am agreeing to the terms then the terms should not change because I broke terms I had with someone else. I understand once I default 60 days with you then I have broken the terms, but to change the terms on already borrowed money because I defaulted somewhere else is insane and leads to self-fulfillment of multiple defaults.

I might be treading water and bailing out the boat, but you aren't going to help your chances of repayment if you suddenly start refilling my boat with water.

DanielJ

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.

David Fischer

"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".

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Travis

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.

aaron

Shouldn't the penalty simply be that interest accues and compounds and a non-payment report drives up the interest rate for additional credit?

aaron

Increasing the rate only increases the risk of default.

CT reader

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?

D

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.

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Abe

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.

Steve

First, we need legislation to force them into a competitive environment and then we'll see........

At the moment, this industry works on legal slight of hand and outright theft. If Congress weren't paid off, their senior executives would be in jail, like Madoff.