The illogical logic of credit card rates

We have been hearing a lot of talk in Washington and Main Street about how credit card issuers are managing risk and rates lately, so I thought it would be a good idea to offer up a quick analysis of the so-called rationale that supports raising rates on deteriorating-credit clients.

The pricing mantra goes like this…

the expected credit losses on the portfolio is rising so we need more revenue to pay for those losses. And we raise the rates more on people with the worst credit scores because they are the most likely to go under.

Well, this is not very sensible, folks. There are several problems with this way of thinking.
First and foremost the issuing card company (that is, issuing the credit i.e. making the credit card loan) is supposed to be in the business of adjudicating credit and taking managed amounts of risk. When they oversell by issueing cards to people who are bad risks the issuing bank/ card company is supposed to take a hit – it’s their fault for making the bad loans i.e. failing to adjudicate credit responsibly. It is not the responsibility of the vast majority of credit card holders to “make it up” for them through higher rates. Allowing credit losses to be built into the portfolio rate base promotes bad credit card sales and shifts the burden of credit adjudication cost to cardholders which is patently unfair.

Second, raising rates on the least-capable-to-pay customers is also inappropriate. The right thing to do – for both the card company and the customer – is to limit and reduce the amount of credit available, not raise the rate. Deteriorating credit status that occurs after after a loan is made (credit authorized / limit granted) is something that was supposed to be assessed and factored into the cost of credit before credit is granted to the customer. The risk of deterioration in credit quality should be taken as a pooled risk at the time the card is issued, not after-the-fact. And even then, does it make sense to push the customer with the worst risks into bankruptcy faster by raising rates ? The answer is clearly NO. Individual credit risks need to be assessed and predicted and factored into credit underwriting before lending to people, not afterwards. It doesn’t even make any sense from a collections perspective, because the high risk=high rate paradigm makes credit quality worse, increasing lending losses. Reducing the available credit amount is the only sensible way to work out a deteriorating risk situation.

And on another note, has anyone noticed that merchants are getting whacked with horrible charges to pay for excessive “loyalty” programs ? My local restaurant gets charged one rate for Amex, another for regular cards and a different rate for premium cards. To him it is all the same – payment for a sanwich and a cup of coffee – but the interchange he gets charged differentiates between cards. So my local restaurant is paying for the bells and whistles on their customers’ cards. That isn’t fair either. So I don’t use a card with my local vendors, I want them to prosper – I pay them cash and that is only fair to them.

David McNab