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The writer is a former chair of the US Federal Deposit Insurance Corporation and author of the upcoming book ‘How Not to Lose a Million Dollars’
The polar ice caps may be melting, but hell is surely freezing over at the prospect of Donald Trump and US senator Elizabeth Warren teaming up.
The veteran Democrat says the US president has asked her to work with him on legislation to cap credit card interest rates at an annualised 10 per cent for one year, a proposal he pushed strongly in Davos this week. The big banks are gearing up to fight this union of the populist left and right. Legislation will be an uphill battle, but at least the drama is casting a spotlight on historically high credit card rates and the burden they place on working families.
The industry claims a 10 per cent cap will make it unprofitable to serve all but the safest cardholders and force it to withdraw credit from millions of customers. But the evidence suggests that banks have a lot of room to reduce rates and still make tidy profits without cutting back on credit availability for most.
Before the 2008 financial crisis, credit card rates hovered at about 12 to 14 per cent, at a spread of less than 10 per cent over the benchmark federal funds rate that determines banks’ costs of short-term borrowing. After the financial crisis, the Federal Reserve lowered the FFR and kept it near zero for more than a decade. But the banks kept credit card rates at about the same level, significantly widening the spread they enjoyed over their own cost of funds.
During the pandemic, the Fed again lowered the FFR to near zero and, again, banks did not significantly lower rates. Post-pandemic, as the Fed raised the FFR to fight inflation, the banks increased credit card rates even higher. Average credit card rates rose to a historic high of about 21 per cent late last year, according to New York Fed data, with spreads over the FFR at levels about double where they were pre-crisis.
Banks have argued that high rates are necessary to cover the costs of riskier customers and that a 10 per cent cap will make it profitable to serve only those with the highest credit scores. But a study by Liberty Street Economics found that spreads are high across all levels of credit ratings measured by so-called Fico scores and that default losses cannot explain the huge spreads above FFR. While delinquencies and defaults have gone up from their pandemic lows, they are still well below pre-crisis norms.
A recent Vanderbilt study concludes that at a 10 per cent cap, banks could continue profitably serving the vast majority of their customers. I have a hard time believing banks would cut off otherwise profitable cardholders to avoid giving them a one-year break on their credit card payments. If banks want to mitigate the impact on their profits, they should look to reduce the huge amounts they spend on marketing and rewards programmes.
Banks argue the cap will hurt the economy by reducing consumer spending and forcing risky borrowers to turn to higher-cost credit such as payday loans. But this is based on their self-serving and unjustified assumption that a 10 per cent cap would force them to pull back on credit en masse. If anything, the cap should boost the economy.
Reducing their credit card bills would free up cash that working families could spend on other things such as food and utilities. It would ease pressure on their budgets so that they did not have to turn to payday loans. If banks are really worried about payday lenders, they should persuade the Trump administration to revive the Consumer Financial Protection Bureau and empower it to crack down on these and other forms of abusive short-term credit.
That said, there are better alternatives to the 10 per cent one-year cap. Ten per cent is too low and would force banks to withdraw credit from the most marginal customers. A higher cap would be more in line with historical norms and preserve profitability for customers with the lowest Fico scores.
Also, what happens when the year is up? Reverting to today’s high rates could create payment shocks for credit card users, precipitating a wave of defaults.
A better approach would be a permanent cap expressed as a spread over the FFR, say 10 per cent. This would be consistent with pre-crisis spreads. It would ensure that banks pass on the benefits when the Fed lowers rates but also allow them to raise rates when the FFR goes up. At the current FFR, it would bring credit card rates to just under 14 per cent.
Americans pay about $160bn a year in credit card interest. By keeping rates high, banks have withheld the full benefits of the Fed’s low-interest policies in another example of how monetary policy does not “trickle down” to Main Street. With the FFR declining again, now would be a perfect time for banks to voluntarily cut rates significantly. Otherwise, an improbable, but politically potent, Trump-Warren team could do it for them.
