Solving the Credit Card Mystery
The behavior of credit card interest rates is mysterious. The rates seem high relative to other interest rates. And while other rates have declined significantly since the early 1980s, credit card rates have not moved down much, with the result that the spread between the Treasury bill rate and credit card rates has doubled over the past decade.</br></br>Credit card issuers have not offered a good explanation of the behavior of their interest rates. About half the states have therefore imposed usury limits on credit card rates. While credit card issuers have been able to avoid these restrictions in many cases by moving their activities to other states, Sen. Alfonse D'Amato (R., N.Y.) is now proposing a national rate cap.</br></br>In fact, however, high and unvarying-credit card rates are not necessarily evidence of a failure of competition in the credit card market. Credit cards are both payment and credit devices. Cardholders can use them in lieu of cash for a variety of retail transactions. At any given time, a bit fewer than half of all cardholders also use them to access a revolving credit line of a preset amount. The use of credit cards as a payments device is growing at the rate of about 10% per year; the amount of credit card debt outstanding is growing at about a 6% annual rate and represents about 30% of all consumer installment credit.</br></br>Providers of "interchange" services (such as MasterCard and Visa) transmit payment information between the cardholder's and the merchant's banks. However, the issuing institution sets the card's terms, including the interest rate, the grace period, annual fees, penalties, and most other card features. While there are relatively few suppliers of interchange services, according to the Nilson Report, the main industry report, there are at least 5,000 credit card issuers in the U.S. Entry into the business is relatively easy, with individual retailers and other commercial entities of even modest size offering credit card plans.</br></br>The existence of this many suppliers normally would be expected to lead to aggressive price competition. Yet credit card rates appear to be very sticky. In addition, the rate of return to banks on credit card assets appears to be high relative to the return observed for other bank assets. Yet actual loss rates do not appear to be very high, averaging below 3% for most of the past decade -- seemingly too little to justify a 12 percentage point premium over the rate of return on a riskless Treasury bill.