In May 2012, The Center for Responsible Lending (CRL) released a research report titled "Predatory Credit Card Lending: Unsafe, Unsound For Consumers And Companies." The purpose of the study was to determine whether there was a correlation between the pricing and marketing practices of credit card issuers and their fiscal performance during an economic downturn. The study examined these predatory practices in existence just before the new federal reform outlawed many of them.
SEE: How To Spot A Predatory Lender
What the study revealed is that those issuers who engaged in more abusive lending practices suffered the largest losses between 2006 and 2010. What is significant about this finding is that it contradicts the issuers' claims that it needs to charge such high fees and interest to mitigate its exposure to high-risk borrowers. The study concludes that the lending practices themselves are the cause of the risk.
Hidden Fees and Interest Rates
Until 2010, credit card issuers had a wide latitude to charge borrowers various fees for late payments, maintenance, non-usage and other card usage. They could also increase the interest rate charged on cards with little or no notification to the customer. Credit card companies touted low- or no-interest cards and encouraged customers to transfer balances from existing cards. When the promotion period ended, borrowers were stuck with a much-higher interest rate, causing many to default on their accounts when the recession hit.
According to the CRL study, default rates were higher in credit card companies that marketed aggressively and hid excessive fees in the fine print of the contract.
As public pressure to regulate the credit card industry intensified in 2008 and 2009, issuers fought back and claimed that if they were not allowed to hike interest rates and charge fees, they would suffer financially even more than they already had. In the first six months of 2009 alone, the top 12 credit card companies jacked up their interest rates by two full percentage points or more on average.
What the companies didn't count on at the time is that the aggressive increase in card rates would tip many borrowers over the edge and into default. The higher rates were meant to compensate the card company for increasing defaults, but ended up causing them instead. The new regulations that restricted the lending practices of credit card companies ended up not only helping consumers, but also helped to stabilize credit card issuers' profits.
In February 2010, the Credit Card Accountability, Responsibility and Disclosure Act (CARD) took effect. The legislation's purpose was to limit the practices of credit card issuers and require increased and more transparent disclosures to borrowers. Interest rate increases were limited to new purchases only and issuers were required to give borrowers 45 days' notice prior to the increase. Late fees were severely restricted and charges for being over the credit limit were virtually eliminated. Every credit card statement had to include a projection of the length of time it would take to pay off the card if only making minimum payments, and how much it would cost to pay it off in three years. Many of the prior industry practices vanished under the new legislation and many of the largest lenders reported decreased default rates in 2010 and 2011.
The Bottom Line
The surprising lesson learned by increasing regulation on a segment of the lending industry was that tightening the rules benefited both the lender and borrower. This lesson may apply to other areas in the financial services sector, including retail lending. The long-term impact of regulation on industry stability and profitably should continue to be studied as new rules are proposed.