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The Federal Reserve Bank has issued new rules that will take effect in 2010, radically changing the way credit card companies treat their customers. Essentially, they are strong protections that regulate interest rates and billing methodologies.
For instance, card companies will be prohibited from charging interest on balances that were paid off in the previous cycle. The rules also forbid card companies from raising interest rates on pre-existing balances. Card companies will be allowed to raise rates only on balances that a consumer accrues after being notified of the rate change. There are exceptions: The rule won't apply to money borrowed on a variable rate card, or when a minimum payment is made more than 30 days late.
Other measures:
- The rules prohibit interest rate hikes during the first year following the opening of an account -- unless the card issuer disclosed that a future rate hike would take effect at a preset time when the account was opened.
- The rules end the practice of so-called deferred interest -- meaning companies cannot retroactively apply interest after advertising a special zero percent.
- The rules prohibit credit card companies from charging a late fee if the bill was mailed to the consumer fewer than 21 days before the due date.
- The rules require payments to be allocated to the highest interest balance first when there are varying rates.
Higher Credit Rates, Lower Limits
The credit card companies, not surprisingly, are dismayed by the new rules, which they view as tying their hands. There have been rumblings that they will be forced to raise rates on all cardholders, reduce credit limits for everyone -- or both.
"Consumers will definitely feel some impact -- it remains to be seen where and how," Peter Garuccio, a spokesperson for the American Bankers Association, told CRM Buyer.
Indeed, the new rules will cost the banking industry more than US$12 billion a year in foregone interest payments, according to a study by the law firm Morrison & Foerster. "That doesn't include the cost of implementation, which will be huge," Partner Oliver Ireland, who participated in the report, told CRM Buyer. "This is definitely going to hurt the credit card industry."
It will have to recoup that money somewhere -- either by charging higher rates or avoiding costs equal to a comparable amount elsewhere, he said.
Revenues for Visa and Mastercard in 2007 were $118 billion, ABA's Garuccio noted. That was a 3 percent increase from 2006.
Consumer Backlash
From the consumer perspective, the credit card industry has long had these regulations coming. The practices have been perceived as arbitrary -- levied solely to wring maximum profits out of customers.
Credit card companies are in the business of making money, of course. Also, it's true that cardholders entered into these transactions with card issuers voluntarily -- and that card companies are taking a risk by lending unsecured money. In fairness, the industry does need flexibility in pricing its products; when its customers default, a credit card company cannot seize a house or a car to mitigate its loss.
Still, there is an overwhelming sense that the enactment of these rules is an act of justice -- and it is worth exploring why. Certainly, it would behoove card companies to examine how the industry got to this point of regulation as they strategize the best ways to implement these rules.
Unfair Policies
A big problem for the banks is that their policies for setting rates are not transparent. They also can be very expensive to cardholders, when a misstep raises a rate from 5.99 percent to 17.99 percent, for example.
Simply put, credit card companies have failed to communicate effectively with customers about their policies. Indeed, their rate-setting practices are largely viewed as downright Machiavellian, if the comments made to the Federal Reserve Bank on the subject are any indication.
One practice consumers particularly loathe is "universal default" -- meaning that if a consumer is late paying a utility bill, for instance, that is justification for jacking up a credit card interest rate, even if the cardholder consistently made minimum payments on time.
A related problem is that pricing methodologies are not standardized. Rates are only tangentially related to the Federal Funds rate -- a key short-term interest rate set by the Federal Reserve Bank. This week, the Fed trimmed that rate effectively to zero; Variable rates that are based on the Federal Funds rate should decline, but no other rate types will. The banks, however, will all get the benefit of this cheap money.
What Moral Authority?
Credit card rates are largely based on something banks call "risk-based pricing." This system allows banks to evaluate a customer's 
risk -- income, amount of credit balances carried, frequency of credit applications -- and then set a rate accordingly.
It is fair that banks tailor rates to individual risk factors. Where the industry has fallen down, though, is in insisting on painting these decisions as completely dependent on the consumer. This is the "moral authority" card the companies routinely play against consumers, Congress and anyone else who questions their policies. In truth, setting credit card rates encompasses more than just risk-based pricing.
For example, credit card companies -- along with mortgage lenders, auto lenders and every other finance provider -- have enjoyed one of the most liquid capital market environments in recent memory. The fact is, card companies have not just made money based on the savvy risk-pricing that they hold sacrosanct. They have also been able to ratchet up their lending because they could bundle the credit card receivables into securities to be resold in the commercial loan markets.
Those markets have dried up in recent months, leaving card companies with one less financial option to safeguard their balance sheets. These practices are common in all industries -- but they illustrate the point that the cost and profit of supplying credit depends on far more than risk-based pricing methodologies.
Needless to say, telling customers that their rates are being raised strictly because of their own behavior -- when that is not entirely true -- does not endear them to their financial service providers. It's even worse when consumers' good behavior is the cause of a rate increase.
For instance, credit card companies do not like people who show signs of defaulting on their debt, but they also don't like people who pay off balances each month, benefiting from the float as well as costing the credit card company administrative fees, writes blogger Don Surber. These people are apparently known in industry parlance as "deadbeats," because they don't deliver the revenues credit card companies expect.
That is a moot point, though. The Federal Reserve has spoken, and the practices most assailed by consumer advocates will be outlawed by 2010. Dire warnings aside, if credit card companies find it profitable, then they will continue to lend. If they won't, then another form of consumer financing will emerge to step into the breach.
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