This week, the Senate is considering its version of legislation
designed to best change certain abusive credit card practices
without damaging the ability of moderate- to lower-income consumers
to get essential credit.
Certain credit card companies deserve no defense for their
abusive practices; however, there is a limit to what Congress
should do as opposed to having the Federal Reserve and other
regulators handle the issue. While detailed legislation on credit
card practices may make legislators feel that they have resolved a
tricky issue, the wrong approach is far more likely to make the
situation for low- and moderate-income workers in need of credit
even worse than it is now.
Unfortunately, even the latest version of the Senate language
contains bad policy and unrealistic requirements and would end up
hurting the very people it is designed to help by denying them
Regulatory Reforms Already in
The best approach to the problem of abusive credit card
practices has already borne results. On December 18, 2008, the
Federal Reserve Board, Office of Thrift Supervision, and National
Credit Union Administration released regulations that will ban most
if not all of the abusive practices that certain credit card
companies use. They were the result of four years of work that
included extensive comments, consumer testing, and other work to
ensure that the rules did affect the very practices that the Senate
believes it is addressing.
What is equally important is that the regulations are realistic
and can be implemented on schedule. While it is usually wise to be
very cautious about a regulatory approach, this is one instance
where years of study have produced a satisfactory result on an
emotionally charged issue. These regulations will greatly increase
consumer protections, change the internal practices of issuers, and
alter pricing. Violating the rules will carry a penalty that could
reach $1 million a day.
Among the many changes imposed by the new regulations are:
- Comprehensive changes to credit card statements to ensure that
consumers both have and can understand the terms of their cards,
what their balance is and how much they need to pay each month, the
consequences of late payment, and information about how long it
will take the consumer to pay off the balance if he or she just
pays the minimum each month. The regulations are very specific on
the layout of the new statement, the language used, and the
- New consumer protections that include limitations on up-front
fees, a longer period between the time that statements are mailed
and the time that payments are due, and a 45-day notice period
before higher rates can come into force.
- Bans on increasing interest rates on both current balances and
certain future balances, paying off low-interest-rate credit first,
and double-cycle billing.
As with all such changes, these regulations will have an effect
on the availability of credit to some customers with less than
perfect credit histories. While credit cards will be cheaper for
many customers, others will find it harder to get them. This is
likely to force some customers to other types of lenders and deny
credit entirely to others. However, the effect of these regulations
is likely to be less drastic than that of the proposed Senate
Pitfalls of the Senate Legislation
While the latest version of the Senate credit card bill is a
major improvement over the version that passed the Senate Banking
Committee by a one-vote margin, it is still significantly flawed.
Although the detailed requirements of how credit card rates should
be set, under what circumstances they can be changed, and even how
fast payments should be credited seem to superficially solve a host
of problems, the language will raise many others.
For instance, the bill would require that consumers must agree
in advance before a credit card company can approve transactions
that go over an individual's credit limit (and thus incur a stiff
fee). This provision may sound good, but it is likely to have the
effect of reducing an individual's credit limit. As the individual
approaches his or her credit limit, the credit card company is
likely to refuse to approve new transactions until it is certain
that there are none in the pipeline that could push the customer
over the limit. This is only one of many detailed requirements that
sound better in theory than they will be in practice.
Other provisions limit the ability to increase interest rates
even in instances where a consumer's financial situation has
changed or where the consumer has made a late payment. While these
provisions sound fair to legislators, the net result is likely to
be accounts that are closed at the slightest sign of trouble.
In addition, both the Senate legislation and its House
counterpart bear their own risks. The simple fact is that in
situations like these, regulations are easier and faster to adapt
to cover new abuses that may develop over time. Given that in any
business it is likely that someone will seek additional profits by
circumventing the rules, an alert regulator is likely to notice and
deal with the situation long before legislation could be amended to
Is There a "Debt Trap"?
In addition to addressing specific practices, developers of the
Senate bill appear to believe that reducing the impact of
high-interest lenders cannot be anything but beneficial for their
customers. Unfortunately, economic literature on the effect that
high-interest lenders have on their customers is spotty, with many
studies as interested in proving a point as in objective research.
Activists take it for granted that there is a "debt trap," where
customers of high-interest lenders find themselves deeper and
deeper in debt to the lender as interest rates and fees combine to
make it impossible for them to repay their loans. Such a trap may
well exist in both specific cases and in general.
However, there is research from the New York Federal Reserve
that suggests that the debt trap may not exist in all situations,
and in fact some consumers may be better off with the presence of
high-interest lenders than they are without them. This paper looks
at Georgia and North Carolina after payday lenders were banned. It
found higher incidences of bounced checks, complaints about the
collection methods of lenders, and bankruptcy filings after the ban
than before it. This suggests that high-interest lenders meet a
definite need, and it raises questions whether a too-stringent
approach to credit card practices may end up causing more problems
than it solves.
Effects on Borrowers
The first question is: Who would be the affected borrowers?
While it is clear from many data sources that individuals from any
and all socio-economic levels can be customers of high-interest
credit card issuers due to either sudden income shocks or poor
financial management skills, the largest proportion of customers
fall into three groups:
- Low- to moderate-income workers who have limited access to
other credit sources either because of low income, poor credit
histories, or the simple fact that few banks and other lenders have
branches that are easily accessible to these consumers;
- First-time borrowers who may have high potential to become good
credit consumers but for now have no credit history and no one
willing to co-sign their loan applications; and
- Consumers who have poor credit histories or who may have just
emerged from bankruptcy and are seeking to rebuild their credit
Credit cards and similar products are primarily priced by the
risk of the customer. Thus, customers with either poor credit
histories or none at all can expect to pay significantly higher
interest rates than those with better credit records. However,
these high rates are usually temporary. As new borrowers
demonstrate their ability to responsibly handle credit, they
qualify for lower and lower interest rates, often by switching
lenders. The same is true for borrowers with poor credit records
who are seeking to restore their reputations.
While it may seem that legislation would encourage lenders to
reduce their interest rates to these borrowers, this is unlikely to
happen. For responsible lenders who base their interest rates and
fees on the risk that the borrower will either not repay the loan
or that it will require extensive contact with him or her to get
payments--a very costly process--the added burden imposed by this
legislation will simply result in their withdrawing from the market
and focusing on more creditworthy customers.
Certain other reputable lenders will continue to offer products
to these borrowers and may even lower their fees, but they will
increase the requirements to qualify in a way that will reduce the
number of potential customers. The combination of higher credit
standards and fewer credit providers will either leave high-risk
borrowers with no credit available or force them into the hands of
less reputable lenders.
As it becomes harder for moderate- to lower-income customers to
get credit cards, many of these consumers are likely to be forced
into the arms of less reputable lenders who charge ever higher
rates for products such as payday loans, car title loans, and other
similar products. Their customers will not find any relief from the
passage of this Senate credit card bill. Instead, less reputable
lenders will be delighted if the result of this legislation is a
rise in the number of consumers forced to use their services.
Ineffective and Counterproductive
While well intentioned, the Senate credit card bill is likely to
either make it harder for certain people to find credit cards at
all or make it even more expensive for them to do so. Although the
explicit language of most of the legislation's provisions appears
to address specific problems, sponsors fail to realize that the
legislation will hurt the very people who need credit the most.
David C. John is Senior Research Fellow in
Retirement Security and Financial Institutions in the Thomas A. Roe
Institute for Economic Policy Studies at The Heritage Foundation.
This paper was adapted from his testimony before the House
Committee on the Judiciary, Subcommittee on Commercial and
Administrative Law, on April 2, 2009.