Wednesday, August 25, 2004

Credit card interest rates: no competition

There's something about the way we use credit cards that doesn't make sense - even to some within the credit card industry. Rohan Gamble is the managing director of Virgin Money in Australia. He says he "can't fathom why" the big card providers haven't been subject to the same sort of consumer pressure to cut their rates as have the banks when it comes to home loans.

Figures prepared for Virgin by BIS Shrapnel show that while the Reserve Bank's official interest rate has plunged over the past eight years (taking mortgage rates down with it) the rates charged on the major credit cards have scarcely fallen. Some of the rates have actually climbed.

It is as if we don't shop around on the basis of the rates when it comes to choosing our cards.
Certainly, that's been my experience.

I was stopped at Sydney Airport by a woman offering me one of the new transparent blue American Express credit cards. I signed up, only to notice later that the annual interest rate was 19.9 per cent. I'm not alone. When a company in the United States renamed one of its cards the "Elvis card" it received three times the usual response.

This stupidity - if that's the word for it - both intrigues and frightens economists... It suggests that at least when it comes to credit cards, one of the fundamental tenets of economic theory doesn't apply and that there's no reward for cutting prices.

Professor Lawrence Ausubel of the University of Maryland in the US has come up with an explanation. It involves what he calls "a very specific form of irrationality".

Ausubel believes that there are two quite different types of credit card customers: those who believe that they will pay their bills off in time, and those who know that they won't.

The first group of customers are beloved by the banks: partly because they are good credit risks (they are able to pay off their credit cards on time) and partly because being human, they often fall behind in their payments anyway.

Roughly half of all US families using cards think they "nearly always pay in full", while at the same time about three-quarters of all active accounts are overdue.

And the banks love this deluded group of customers for another reason as well. When they sign up for their cards, they genuinely don't care what the interest rate will be. Why should they, when they don't intend to pay it?

(Some in this group might even welcome a card with a high interest rate. It would give them an incentive to make sure they paid on time.)

The way to compete for these valuable if often misled group of customers is through anything other than a low interest rate. They offer service, convenience, rewards and image. That's what I was promised at the airport.

The second group of customers are different. The rate of interest is about the only thing that matters to them. They are people who know that they are going to get into debt and stay in debt, month after month. In many cases, they will be unable to get out of debt. In the industry they are known as "revolvers". They are by definition worse credit risks.

So what would happen to a credit card provider that decided to strike out on its own and grab more business by cutting its rates? In Ausubel's view it would gain hardly any more of the deluded desirables. Instead it would be flooded with applications from high-risk revolvers. Slashing rates might mean commercial suicide.

Even short-term low-interest honeymoon rates have their risks. They can attract revolvers who "card surf", jumping from one short-term low rate to another.

Economists at Australia's Reserve Bank examined our credit card market some years ago and found circumstantial evidence for the sort of effect that Ausubel was describing. They concluded that in those circumstances there might be a case for government intervention to force rates lower.

Doubtless to the relief of Australia's major banks our Reserve Bank took the idea no further. And it now looks as if it won't need to.

Virgin Money is acting as if it has never heard of Ausubel, and Gamble confirmed to me this week that he hadn't. He says by competing primarily on the basis of a good interest rate (12.4 per cent) he's been able to grab 400,000 customers from Australia's major banks in just over a year - 100,000 of them from the Commonwealth Bank.

He says the thing that's astounded him is that the Commonwealth Bank hasn't fought back with a lower rate of its own. Instead it and the other banks have upped their advertising. "There are now seven credit card ads on television. All of them promote an image. None focus on the rate."

It is as if the established banks are sitting back waiting for the upstart to fail, buried under a mountain of less than desirable "revolvers".

Gamble insists this isn't happening. "Our customers have the same profile as those of the existing banks: an average age of 40, a broad spread of demographics and so on."

It might be that things are changing. Some of the desirable deluded customers may be wising up. Four years ago, 80 per cent of Australian credit card bills were outstanding at any one time. Today the figure is a more prudent 75 per cent.

Mortgage brokers and specialist websites have made it respectable to shop around for mortgage rates. Those same websites offer information about credit card rates.

Virgin says it is lobbying the authorities to require card companies to include an honesty box in their advertising outlining the actual cost of using their cards, in the same way as the mobile phone companies are required to do.

Time may be running out for the "happy idiots", blissfully unaware of how much they are enriching their credit card companies, too lazy to shop around and not believing that it matters. It's up to us.