The problem with banning floors on credit-card rates

By Felix Salmon
January 15, 2010
released its final rule governing credit card issuers. The whole thing can be downloaded here; it's a mere 1,155 pages long. And credit card consultant Timothy Kolk has found something rather worrying buried within it.

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On Tuesday, the Federal Reserve released its final rule governing credit card issuers. The whole thing can be downloaded here; it’s a mere 1,155 pages long. And credit card consultant Timothy Kolk has found something rather worrying buried within it.

Here’s the language from page 317:

Consumer groups and a member of Congress raised concerns about two industry practices that, in their view, exercise control over the variable rate in a manner that is inconsistent with revised TILA Section 171(b)(2). First, they noted that many card issuers set minimum rates or “floors” below which a variable rate cannot fall even if a decrease would be consistent with a change in the applicable index. For example, assume that a card issuer offers a variable rate of 17%, which is calculated by adding a margin of 12 percentage points to an index with a current value of 5%. However, the terms of the account provide that the variable rate will not decrease below 17%. As a result, the variable rate can only increase, and the consumer will not benefit if the value of the index falls below 5%. The Board agrees that this practice is inconsistent with § 226.55(b)(2). Accordingly, the Board has revised comment 55(b)(2)-2 to clarify that a card issuer exercises control over the operation of the index if the variable rate based on that index is subject to a fixed minimum rate or similar requirement that does not permit the variable rate to decrease consistent with reductions in the index.

In English, what this says is that credit card companies can’t put a floor on their credit-card interest rates. If you’re paying 12 percentage points above Libor, you pay 12 percentage points above Libor, no matter how low Libor goes. On page 516, the Fed gives an example: even if the terms of a credit-card contract include a floor below which an interest rate cannot fall, that floor can no longer be enforced after February 22.

Sounds great, right? Surely if there’s no minimum interest rate, that’s got to be good for consumers? Actually, no: there’s a problem here, due to the fact that interest rates are very low right now.

Let’s say that I’m a customer-owned credit union, and I want to issue my customers a card carrying a low interest rate of 9.9%. I also want to protect myself in case rates rise a lot, so I put in language saying that the interest rate always has to be at least 3.9 percentage points over the Prime rate. Prime is currently just 3.25%, but if Ben Bernanke were to raise the Fed funds rate past 3%, then the rate on the credit card would begin to rise.

As of February 22, that kind of product will be illegal. The variable-interest bit (Prime + 3.9%) is fine. But if you have a variable-interest credit card, you can’t set a floor any more. Which means that since Prime is just 3.25% right now, the interest rate today would be set at an uneconomical 7.15%.

As a result, if I want to charge a 9.9% interest rate today, I need to peg the card’s interest rate at Prime + 6.65%, and the rate on the card will start rising as soon as Bernanke raises rates by so much as a quarter-point.

Clearly a Prime + 3.9% card with a floor of 9.9% is a better deal for consumers than a Prime + 6.65% card. But the Fed is banning the former product, and forcing issuers into the latter.

The point here is that banks need to charge at least 10% or so on their credit cards, no matter how low prevailing rates are, just because of charge-offs and expenses. That doesn’t mean they always need to charge at least 10 percentage points more than the Fed funds rate, however.

I do think that floors on credit-card interest rates are a bad thing if they’re set so that consumers can’t benefit from falling rates. But right now, when rates are at zero, that’s really not an issue — and banning floors can sometimes make products worse rather than better. I wonder whether the Fed understood this when it put its rules together.

5 comments

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> The point here is that banks need to charge at least 10% or so on their credit cards, no matter how low prevailing rates are, just because of charge-offs and expenses. That doesn’t mean they always need to charge at least 10 percentage points more than the Fed funds rate, however.

I would be interested in more detail on why this is the case. Is this because charge-offs are higher in recessions, and interest rates are lower, so that charge-offs are higher when interest rates are lower? I would assume expenses don’t vary with interest rates; if charge-offs didn’t, I would assume what would be needed would be a constant margin above the bank’s cost of funds.

Incidentally, it’s worth noting that for just about any product the Fed could ban, an example can be constructed where it really would be in the consumer’s interest. The move toward vanilla options, especially where it’s a move toward making vanilla the only choice, is defensible only insofar as it’s comfortable trading off the benefits (to consumers who are ignorant, naive, or simply time-constrained) against the loss of contractual freedom to tailor a specialized deal that may be better for all parties.

Posted by dWj | Report as abusive

The Fed is misinterpreting the statute, which allows:

“(2) an increase in a variable annual percentage rate in
accordance with a credit card agreement that provides for changes in the rate according to operation of an index that is not under the control of the creditor and is available to the general public;

A rate change based on an index with a floor is still a change in the rate according to operation of an index that is not in control of the creditor. “Control” refers to control of changes in the index. Obviously the creditor controls the initial selection of the index and margin, but that doesn’t violate the statutory provision. If the Fed doesn’t fix this they will have trouble defending it in court–the precedents go back to the late ’70s early ’80s.

Posted by janon | Report as abusive

dWj — I think the point here is that a bank’s cost of funds, if it funds itself through deposits, can actually be lower than the Fed funds rate when the Fed funds rate starts to rise.

And I don’t think anybody is saying that vanilla options should be the *only* choice. We proponents of vanilla options would just like to see them mandated as *a* choice.

Further reading of the 1155 page document (especially p. 518ff, with credit given to Mr. Chris Joy at PSCU) leads to perhaps the real intention of the Fed here: to make responding to this new limitation impossible. Though the elimination of floor rates is a new element, a 45 day notice requirement in rate changes has been in place since August. But note: the new rules (including no floors)came out 41 days before the effective date. Page 518+ then goes on to state that new rates have to go into effect BEFORE Feb 22 if they are to change rateson existing balances, which is impossible from the date the rules came out. A bureaucratic jujitsu move worthy of a Kafka novel.

To illustrate, assume you are the nicest-of-the-nice credit union, and you give cards at Prime+0%, but have a 8.9% floor (you need this as funding costs, expenses and charge-offs will eat up about 12% of balances every year in this product while non-interest fees generate about 4% revenue…leading to break even.) You have tried to provide a product where you are as low priced as economically viable in all rate environments. Well, now you will have to change those effective rates to 3.25% after Feb 22,and you do not have the 45 days required to change terms. The Fed just potentially bankrupted you- you, the one they would presumable want to celebrate.

Posted by TRKAdvisors | Report as abusive

@TRKAdvisors

I’m not sure the situation is as dire as you presented. The restrictions on floor rates means that any card issuer that has a floor rate on a variable-rate account will not be able to utilized the “variable-rate exception” in 12 CFR 226.55(b)(2). In other words, the issuer loses the ability to follow any changes in the underlying index. But, this does not mean the issuer will have to remove the floor and lower the APR. In fact, it creates an awkward situation where a card issuer has disclosed a variable-rate to the consumer but, according to the Fed, can not increase the APR even if the index changes. According to the Federal Reserve, this is for the consumer’s protection. But, as Felix pointed out there will be situations where consumers will not benefit and, in fact, might be harmed (not to mention consumer confusion).

Posted by SteveVB | Report as abusive