Should Central Bank regulate credit card industry?

By Tharindra Ranasinghe Last week, Bank Supervision Department of the Central Bank instructed to reduce the interest levied on credit cards to a level between 24 and 36 percent. The press release by the Central Bank notes that interest rates charged on credit cards remain at very high levels of 33 to 48 percent despite significant reductions in market interest rates. Clearly, credit card users with outstanding debt would welcome such a move and hope that banks would duly comply. The Chairman of Payment Card Industry Association of Sri Lanka told a newspaper that banks would comply with the request beginning early February 2010.

On the other hand, proponents of free markets would view such directives as unnecessary state interference. According to them the current rates charged must be the ‘equilibrium’ rates that compensate for credit risk of banks, and competition among banks should eliminate any excessive profiteering. Attempts to impose lower interest rates will only disturb this equilibrium resulting in severe adverse consequences. Allure of free markets The idea of free markets is very alluring as they predict the optimal outcome without the need for any external interference. According to this idea, as long as competitive markets operate free from regulatory interference, competition should lead to the equilibrium where firms only make normal profits to justify their survival and customers end up getting the best deal. Attempts to regulate will only disturb this blissful harmony and will leave consumers worse off due to weakening of competitive forces. Are Credit Card markets free? Notwithstanding the academic elegance of the above argument, research continues to show that credit card markets do not seem to fit in to this model. For example, inspite of being extremely competitive, credit card companies in the USA have managed to charge excessive interest rates over the years and introduced various types of hidden fees and penalties. Moreover, interest rates of credit cards tend not to go down even when cost of capital for banks goes down significantly. Not surprisingly, credit card business continues to be one of the most profitable segments of US banks. Such behavior seems a paradox under classic economic theory, given the high level of competition and lack of evidence on any collusion among banks (In economics, the term ‘collusion’ refers to instances where some parties (e.g. firms) get together into unlawful agreements where other parties (e.g. consumers) will be unfairly exploited). What does research say? A considerable amount of research has been carried out to shed light on why credit card markets do not follow the free market theory. Some possible explanations have emerged. One potential reason why banks seem to be able to charge excessive rates is that at the time of applying for a card, the typical consumer expects he would be able to pay all outstanding balances within the grace period where no interest is charged and therefore do not pay much attention to the interest rate. Moreover, it is argued that search costs (costs involved with looking for the best deal) and switching costs (costs involved with moving out of current card and getting a new one) faced by the consumer prevents the functioning of perfect competition. Additionally emerging research in economics suggests that ‘equilibrium’ behavior proposed by classic economic theorists and proponents of free markets is considerably flawed. For example, research in the game theory shows that at times, monopoly like behavior can emerge even in markets with many competing firms without any explicit collusion among them (In other words, a sort of an “implicit collusion” can emerge as an alternative equilibrium). If banks can end up abusing credit card users in developed and highly competitive markets such as the USA, the concerns would be only greater in a country such as Sri Lanka where the level of competition is much lower. International trends Abusive practices for credit card firms have been a major concern in the USA over the years. Earlier this year, the Congress passed the Credit Card Accountability Responsibility and Disclosure Act of 2009 to curb these abuses. The bill received strong bipartisan support and passed the Senate with 90 votes in favor and 5 against and the House of Representatives 361 to 64. This bill attempts to put an end to abuses such as surprise interest rates hikes, shifting due dates for monthly payments, and excessive fees. If the guardian of global capitalism sees the need to rein in on credit card firms and regulate the industry, “no interference” arguments of free market proponents are unlikely to hold much ground. Applauds Very often, we chastise state institutions (with very good reasons to do so) for their inefficiency, incompetence, and policies that are not well thought out. However, it is also important to give them due credit when they make policy decisions that are to the betterment of the majority instead of few interested parties. Central Banks deserves a round of applause for its attempts to bring some sense in to the functioning of credit card firms. However, the battle is not won by any means. There is no doubt that banks will attempt to recoup the profits lost due to lower interest rates by other means such as excessive fees and charges, retroactive penalties, and shorter grace periods. The Central Bank and the consumer need to be extremely vigilant.

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