One the mystifying topics in Finance
is the unmovable interest rates that banks charge on credit card balances. For the
past decade, these have hovered around 25% p.a. while bank funding costs remained
below 3% p.a.
Add to that charge-offs of
around 3% p.a. and banks generate gross margins of 19% p.a. from which to pay operating
and advertising expenses. Thanks to economies
of scale, large institutions should clear well over 10% p.a. before tax. And of course, this is before factoring any debt
leveraging which boost ROEs.
Why is it that competition doesn’t
squeeze these fat margins? Is the market
really operating as it should?
Bankers will argue that they have
nothing to gain by lowering their lending rates as this would attract the
riskier clients, those who max out on their cards and have difficulty paying
them on time. Perhaps. But that still doesn’t address the question
as to whether US borrowers are overpaying for credit and, in doing so, suffer
undue hardship.
It so happens that the
current US situation is not unique, and there is a recent precedent where a government
intervened to profoundly recast a seemingly well oiled but uncompetitive consumer
finance market: Japan in 2006.
The Japanese consumer finance market
For years, Japanese banks
limited themselves to secured consumer lending, namely mortgage financing.
Unsecured lending is a
different ballgame: lenders need to assess their clients’ ability to repay, or
roll over loans; this calls for a different kind of credit analysis and for access
to extensive credit data bases. Finally,
lenders must ensure that their revenues (and therefore lending rates) cover
their expenses.
Lacking all of these, Japanese
banks left the field open to money lenders - thousands of them - ranging from
small, at times illegal outfits, to large and sophisticated publicly traded
firms.
The opening was provided by
the Investment Deposit and Interest Law which allowed lending rates of up to
29.2% p.a., well above the 20% p.a. ceiling set by the Interest Rate
Restriction Act of 1954 for loans up to ¥1,000,000.
This opportunity to makes
tons of money triggered an impressive burst of creativity: the association of consumer finance companies
set up a vast and up-to-date credit bureau; top lenders invented ATM-like
terminals through which customers could obtain new loans in under 20 minutes;
they developed algorithms that not only helped them approve new loans but size
and price them to maximize profits; basically, they outsmarted, outperformed
and out-earned traditional banks.
There was however a downside
for society. Borrowers could easily
contract several loans from different lenders, and with rates of 29.2% p.a., they
stood little chance to repay them, which left them perpetually in debt. Consumer lenders could use rough collection methods, sending staff
to harass debtors at home, even suggesting they sell a kidney to meet mounting
past dues. Finally, the biggest lenders
and their founders became very rich and very arrogant[1].
In 2006, out of the blue, the
Japanese Establishment stroke back, hard.
First, the Supreme Court ruled that interest rates in excess of 20% (the
so-called Grey Zone) had been illegal. Then, the Japanese Accounting Board demanded
that consumer lenders set aside reserves to meet client demands for repayment
of excess interest paid going back up to five years; for the top four lenders
alone, the initial reserves topped $7.5 billion. Finally Parliament voted new lending laws
which “defanged” the lending upstarts: credit bureau data would have to be
shared with banks, customers would be limited in their ability to contract
multiple loans and to a total value of 1/3 of annual income[2],
lending rates would effectively be capped at 15%-18%[3],
finally criminal penalties were stiffened.
The consequences for the top
money lenders were harsh: Takefuji
collapsed, Acom and Promise fell under the control of Mitsubishi UFJ and
Sumitomo MFG respectively, Aiful survived as a smaller entity after its founder
recapitalized it.
Back to the US
There are substantial
differences between US credit card lenders and the Japanese consumer finance
companies of a decade ago, particularly with regards to the collection process. But there are important economic and social similarities.
Unsecured consumer debt in
2006 in Japan was not at levels that threatened the economy, and the same can
be said of the US situation today. But in
both countries, underlying tensions were building under the surface.
Here, it is not difficult to
imagine a new backlash against banks in general, and credit card interest rates
are one area where the big players are both very dominant and apparently uninterested
in competing on price. I, for one, can
imagine a political figure such as Senator Warren seizing on the opportunity to
take on the Consumer Financial Protection Bureau and ask why consumer credit
rates are both so high and so static.
[1] I recall a very rich and very smart founder,
who had been invited by Nomura Securities to meet investors, openly boast that
he was far more bankable than them.
[2] In practice, the new law made it difficult
for customers’ total loans to exceed ¥1,000,000 or ¥500,000 with one single
lender.
[3] 18% for loans up to ¥1,000,000 (US$9,400 at
today’s exchange rate) and 15% for loans beyond that amount.
