Credit cards were first made broadly available to individuals for consumer spending in the early 1950s by major department store chains. The cards were furnished as a convenience to the stores' regular "charge account" customers; they also provided a more efficient means of processing transactions and managing accounts. Customers were expected to pay for charged items in full when they received the monthly bill, and no interest fee was imposed. Retail firms believed that customers might spend more freely if they could "buy now and pay later" and might more frequently shop at stores where they had charge accounts. The firms were willing to receive payment on a delayed basis, and without interest, in exchange for a larger volume of sales. Most stores levied a penalty fee of 1.0 per cent or 1.5 per cent per month if full payment was not received within the billing period. The fee was set relatively high (compared with general interest rates) as much to discourage customers from making partial payment as to generate income by extending longer-term credit.
Entry of Banks into the Market: Commercial banks eventually began to recognise the potential profitability of providing open-end financing to consumers, many of whom apparently were willing to pay high rates of interest to obtain unsecured credit conveniently. Marketed mainly by banks, the general-purpose credit card for individual consumers came into broad use in the mid- to late 1960s. To make bank cards appealing to consumers who already had department store cards, the banks granted cardholders the same interest-free "grace period" of twenty-five to thirty days that was customary for store cards. However, the banks also imposed servicing fees (called merchant discounts) on card-honouring merchants, mainly smaller retail businesses that were persuaded to accept bank credit cards as a means of competing with the major chain stores.
For many years, bank credit card operations were only marginally profitable, despite interest rates comparable to those on store cards, as start-up and operating costs per dollar of receivables were relatively high and a sizeable proportion of cardholders remained "convenience users," paying balances in full each month and thereby avoiding finance charges.
Current Industry Structure: Today, although the largest institutions command a sizeable share of the total market, thousands of issuers provide credit cards. Approximately 6,000 commercial banks and other depository institutions market general-purpose credit cards (predominantly under the VISA or MasterCard label), each setting the terms and conditions on the cards they issue. Another 12,000 depository institutions act as agents for issuers and distribute credit cards to consumers. Major retailers continue to provide store-specific credit cards; Sears' store card .
Current Credit Card Holding: In the thirty years or so since commercial banks entered the market in significant numbers, the credit card has become a familiar financial tool to the vast majority of American families. Today, roughly 70 per cent of all US families have at least one credit card account, up from about 50 per cent in 1970 . Most card-holding families, in fact, have several different accounts. A 1989 survey of consumers sponsored by the Federal Reserve found that three-quarters of card-holding families had more than two credit card accounts, with the average number of accounts held by all card-holding families approaching six.
Not only has credit card holding become much more prevalent in the past twenty years, but the types of cards held have changed dramatically . In particular, the holding of bank cards (defined in the survey as "bank type" cards, including VISA, MasterCard, Discover, and Optima) has risen substantially. In 1977, 38 per cent of all U.S. families had a bank card, up from 16 per cent in 1970. By 1989, the proportion had increased to 54 per cent. Bank-card holding likely has edged up since then, with the development of major new plans by recent entrants into the market and continued growth in the operations of longtime market participants.
Functions of Credit Cards: Credit cards serve two distinct functions for consumers: a means of payment and a source of credit. Consumer sensitivity to various aspects of credit card pricing reflects these two types of use.
Credit Cards as a Means of Payment; Although cash and checks continue to be the dominant means of completing transactions, credit cards are an important and growing alternative.
Consumers who use a credit card principally as a payment device most likely would, in selecting a card, focus on the level of any annual fee, the length of the grace period, the availability of desirable enhancements, and the level of authorised charges (the credit limit). The stated interest rate is unlikely to be of much importance to consumers who view their cards mainly as a transactions device.
Costs of Credit Card Operations: Both the level of credit card interest rates and the changes in rates over time reflect the costs of providing credit card services. Therefore, an understanding of the behaviour of credit card interest rates rests in part on an examination of costs. Two aspects of the cost issue warrant particular attention: comparative performance across product lines and comparative performance among different card issuers.
Differences Across Product Lines: The cost structure of credit card operations differs significantly from the cost structures of other types of bank lending. On balance, credit card activities involve much higher operating costs and greater risks of default per dollar of receivables than do other types of bank lending. In addition, the cost of funds is a relatively less important component of the total cost of credit card operations than it is for other types of credit.
The degree of credit risk is a key feature that distinguishes credit card lending from most other bank lending. Credit extended through credit cards, unlike most other forms of bank credit, is unsecured. Once available, a line of credit is exercised at the cardholder's option, and the card issuer has little control over how leveraged the cardholder may become through additional borrowing elsewhere. A cardholder may be inclined to use the credit line under conditions least favourable to the lender, that is, when the cardholder's net worth is low or his liquidity is impaired (due, for example, to loss of employment).
Although advances in automated processing have substantially improved operating efficiency over the years, the costs associated with processing a large volume of relatively small transactions and of servicing a large number of accounts make credit card operations more costly per dollar of receivables than other types of bank lending. As noted, losses on credit card plans (including losses due to fraud) have also been higher than losses on other types of credit.
Data suggest that credit card issuers must generate relatively higher levels of revenue per dollar of receivables to cover costs than is necessary for other types of lending. Although card issuers obtain noninterest revenue from merchant discounts and from a variety of fees (such as annual membership fees, penalty charges, and fees for cash advances), the amount is not large enough in most instances to eliminate the need for substantial interest income from credit cards. Furthermore, interest actually received on credit card balances is much less than the stated rate might indicate, because convenience users generate little or no revenue from finance charges.
The historical unresponsiveness of credit card rates to general rate movements, however, seems to reflect special period-specific circumstances as much as any particular recurrent condition. In the 1960s and into the 1970s, funding costs were relatively stable while operating costs moved through a high-cost start-up phase into a period of increasing efficiency. As discussed earlier, bank cards initially were priced in line with store cards and earned rather meager profits; as operating efficiency improved, rates held steady instead of declining with costs, and profits rose from low levels. It was not until the inflationary period of the late 1970s and early 1980s that market interest rates soared and deregulation of rates on deposits led to sharp increases in funding costs. At that time, however, statutory ceilings prevented much upward adjustment of credit card rates, and by the time states acted to raise ceilings, interest rates generally had crested. When funding costs began to decline significantly after 1981, credit card rates remained mostly at their existing levels, in part because they had been constrained from rising to an equilibrium level when funding costs were climbing; the decline in funding costs tended to restore equilibrium. In addition, demand for credit card credit rose sharply after 1982, as is evident in the rapid growth of such borrowing as the economic recovery picked up steam. The strong demand allowed credit card issuers to expand their receivables without having to compete intensively for market share, minimising the pressure to reduce prices.
By 1984, the profitability of credit cards had risen above that of most other forms of lending, and it remained relatively high through the end of the decade. This rather long period of high profits raises the question of why competition did not at some point exert heavier downward pressure on credit card rates. One possible answer is that, as banks broadened the market by distributing cards to individuals of lower creditworthiness, a larger risk premium was incorporated into the rate structure, tending to keep rates up. The persistently high credit card interest rates in the latter half of the 1980s may have reflected anticipation of higher credit losses, but the unusually long economic expansion postponed the realisation of those expected losses.
Credit Card Profitability: Data on the performance of credit card operations suggest that higher levels of credit card delinquency and default have raised the costs of credit card operations in recent quarters. A reduction in the cost of funds during the same period, however, has largely offset the losses, helping to maintain relatively strong earnings for the industry as a whole.
Consumer Sensitivity to Interest Rates: Full exploration of the behaviour of credit card rates requires an examination of the demand side of the market as well as the supply side. In general, one would expect markets where buyers are highly sensitive to price (in this case, to interest rates) to exhibit more competition in pricing than markets for products where some other attribute, such as convenience or the level and quality of service, is the overriding concern.
Whether credit card issuers compete to attract and hold customers by lowering interest rates depends in part on the sensitivity of current and potential cardholders to differences in rates among issuers. The repayment habits of cardholders are, in turn, a key determinant of their responsiveness to interest rates charged.
Repayment Practices: Users of credit cards fall into two broad categories--convenience users and revolvers. Convenience users are those who usually pay off their balance in full during the interest-free grace period, thereby avoiding finance charges; revolvers are those who usually do not pay their balances in full and thereby incur finance charges.
Credit card users may occasionally deviate from their usual repayment pattern: Convenience users might repay an unusually large purchase in instalments, or an unforeseen income disruption might cause them to alter their customary behaviour; revolvers might sometimes repay their outstanding balance in full, for instance, when they receive a Christmas bonus or a tax refund, or when they consolidate debts.
Several consumer surveys have explored the repayment practices of cardholders and have obtained highly consistent results over time. In surveys sponsored by the Federal Reserve in 1977, 1983, and 1989, roughly half the families that reported using credit cards said that they nearly always paid their bill in full each month. The latest of these surveys, however, also indicates that a higher fraction of cardholders are revolving balances at any one time than their responses to questions about customary repayment practices suggest. The 1989 Survey of Consumer Finances found that 60 per cent of surveyed cardholders had carried over balances from the previous month ; industry statistics generally show that about two-thirds of accounts are revolving at any point. Nonetheless, the important factor is how consumers perceive their own behaviour, as it is this perception that will guide their credit-shopping activities and their sensitivity to credit card interest rates.
Recent Competitive Developments: Several reasons for the relative rigidity of credit card interest rates in the past have been cited here. Historically, special conditions, such as high startup costs and state-mandated rate ceilings, have stifled movements of credit card rates. On the supply side of the market, changes in funding costs are less important to credit card operations than to other credit activities, and the risks inherent in this unsecured form of lending seem generally to increase at times when costs of funds are declining. Because funding costs account for a comparatively small part of total costs for credit card programmes, the favourable effect of declining funding costs is more likely to be offset by increases in other costs. On the demand side, credit card users have tended to be relatively insensitive to interest rate levels in their decisions to acquire or to keep a particular card. Consequently, card issuers have tended to compete on factors other than price.
In the past several months, however, much of the rigidity in credit card pricing has been breaking down, with a growing number of issuers reducing rates 2.0 to 4.0 per centage points. This development has not been readily apparent in published measures and lists of credit card rates, in part because lower rates have been made available to selected groups rather than across the board.
Exerting downward pressure on credit card rates has been an unusually steep decline recently in the cost of funds, possibly coupled with a charge-off experience during the 1990-91 recession that may have been less damaging than allowed for in past pricing decisions. For example, rates that banks pay on certificates of deposit of various maturities have dropped as much as 3.0 per centage points since the middle of 1991, the sharpest decrease in this key element of funding costs in a decade. Meanwhile, the rise in delinquencies and charge-offs during the latest recession appears not to have greatly exceeded increases during other periods, despite the expansive lending practices of the preceding few years. Perhaps reassured by this relatively favourable loss experience, card issuers may now be willing to build a smaller margin for potential write-offs into rates charged. Thus, as a result of both sharp declines in funding costs and a more optimistic assessment of risk, issuers may believe that they now have more latitude to reduce rates than they have had before.
Another factor that may be applying downward pressure on credit card rates is the increased difficulty of acquiring new customers in a relatively mature product market. The great expansion in card holding during the 1980s has brought the market nearer to saturation, making it more costly to attract new customers without offering substantial enhancements, waiving annual fees, or accepting greater credit risks. The high costs of attracting new customers in a competitive, saturated market places a premium on retaining existing customers, particularly those who revolve balances and pay on time. Reducing rates is one way to curtail attrition.
For the most part, card issuers have lowered rates selectively. In some cases, they have targeted their solicitations to individuals deemed to have certain desirable characteristics, an approach made more feasible by the development of extensive data bases and improved techniques for screening potential cardholders. Some of the largest national issuers have segmented their cardholder bases according to risk characteristics, offering reduced rates to a select group of existing customers who have good payment records; higher-risk late-paying customers are still charged higher rates. Many of the lower-rate programmes involve variable rates; because the rates on such accounts change automatically as the index rates move, the use of variable-rate procedures avoids some of the regulatory and public relations problems involved in raising rates (when funding costs rise) under a fixed-rate plan.
In addition to these supply-side developments, some increase in consumer sensitivity to rates is probably also contributing to the recent reductions in credit card rates. Whether the relative importance of interest rates to consumers has changed is not clear--such factors as service or enhancements may still carry more weight with most cardholders. However, spreads between credit card rates and rates received by consumers on deposits or other interest-beating assets are wider than they have been for two decades. Moreover, with nonmortgage interest payments no longer deductible on federal income tax returns, a given rate of interest is effectively higher than in the past for those who itemise deductions. Therefore, other things equal, cardholders likely are more prone to respond to lower-rate offers than they have been in the past. In addition, the weak economy of the past two years has forged a thriftier, generally more cautious consumer, one more likely to be concerned about the size of interest payments. Increased media attention to the topic and the widespread availability of lists comparing rates charged by different issuers have probably fostered at least some increase in overall awareness of credit card rates.
An important catalyst increasing the focus on rates as a marketing tool has been the willingness of some prominent card issuers to take the lead. AT&T's entrance into the market as an aggressive price competitor has been significant. The firm's emphasis on price has been exemplified first by its offer to "charter members" of a lifetime exemption from annual fees, and lately by its heavy advertising of the declines in rates for all cardholders resulting from its variable-rate formula. After American Express introduced its risk-based pricing structure for the Optima card in February 1992, other major issuers lowered rates in some fashion to some customers. One reason these actions are not more evident in published averages is that in most cases issuers have kept rates for the largest portion of their standard plan customers at their previous levels. The Federal Reserve's series for the national average bank-card rate mentioned earlier, for example, includes a bank's "most common" rate, and that rate is still usually the bank's high standard-plan rate.
Card issuers also may have felt pressure to reduce rates in the aftermath of a brief effort in the Congress in November 1991 to legislate a national ceiling on credit card rates. A bill to do so was passed by the Senate but did not become law. How critical a role that effort played might be questioned, however, in view of the lack of any discernible effect from a similar attempt to control rates in 1986, when two such bills were proposed. Coming at a time when other forces were working to lower rates, however, the recent congressional attention may have hastened the process.
In the future, segmented rate structures will probably become more widespread as lenders continue to try to categorise accounts by their profitability and to price them accordingly. Flexibility in rates will likely persist, with more issuers converting to variable-rate plans or offering a choice of fixed- or variable-rate plans. "Quantity discounts" whereby lower rates are charged on higher balances may become more common as well. Further consolidation in the industry seems likely, too, as less-efficient operations are sold to lower-cost issuers. Nevertheless, levels of credit card rates seem certain to remain comparatively high, because revenues still will have to be large enough to cover comparatively high operating and default costs.
This article was prepared by Glenn B. Canner and Charles A. Luckett of the Board's Division of Research and Statistics. Wayne C. Cook and Mark A. Peirce provided research assistance.
(Copyright 1992 Board of Governors of the Federal Reserve System)
Developments in the pricing of credit card services
FE Team | Published: June 28, 2007 00:00:00 | Updated: February 01, 2018 00:00:00
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