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FRBSF

WEEKLY LETTER

December 27, 1985

Credit Card Controversy
Credit cards are once again in the financial news.
The current controversy centers around the failure
of credit card finance charge rates to follow the
decline in other market interest rates. Consumer
groups and some members of Congress have
recently protested that bank card finance rates,
which average about 19 percent nationwide, are
usuriously high given the relatively low average
cost of bank funds, currently estimated to be less
than 10 percent (see chart). As a result, three bills
have been introduced into Congress that would
establish a nationwide usury ceiling on credit card
rates.
Credit card issuers have countered by arguing that
the current level of bank card interest rates reflects
the realities of pricing a complex product in a
highly competitive marketplace. Besides finance
charges, other pricing decisions include the level of
annual fees, the billing cycle to be used, the length
of the interest-free grace period, the types of
enhancements included, and various other late
fees and service fees. Bankers note that the cost of
money to fund credit card operations represents
only a fraction (typically 40 percent or less) of the
overall cost of operating a credit card plan. Other
costs, which include various processing and billing
expenses and fraud and credit losses, are
significant and do not vary with the cost of money.
This Letterexamines the nature and scope of the
credit card product and its use within the U.S., and
offers some observations on the possible
implications of a nationwide usury ceiling on credit
card rates.

Motivation for card use
It is estimated that Americans were using 700
million credit cards, or more than three cards per
capita, to purchase nearly $300 billion worth of
goods and services at the beginning of 1985. The
popularity of credit cards is probably due to the
numerous advantages they offer as a payment
device. The nature of these advantages, moreover,
has spawned two generally distinct patterns of
credit card use among consumers. The first is
"convenience" use in which card users emphasize
the transaction nature of their credit cards by

regularly paying their outstanding balance in fuil
each month and incurring no monthly finance
charges. The second is "revolving debt" use in
which the credit card is used as a source of credit
by individuals who only infrequently pay their
entire outstanding monthly balance.
Each method of use offers certain advantages over
cash, checks and other means of payment.
Convenience use minimizes the need to carry cash,
allows the user to defer payment for goods and
services for a short time, and establishes a
payments record of purchases. Convenience users
can also use their cards to bridge gaps between
income receipts and expense disbursements. In
certain cases, too, consumers who use credit cards
can exercise their legal right to withhold payment
for goods of disputed quality.
Revolving debt users, in addition to realizing the
above advantages, benefit by being able to vary
debt to match exactly the amount of the
purchased good and to avoid the need to file
multiple credit applications (as in the case of
personal loans, for example). Thus, the use of a
credit card is a more convenient and less timeconsuming way for consumers to take out a loan.
And, unlike fixed payment personal loans,
revolving debt users also have considerable
flexibility in the timing and amount of debt
repayment.

Card holdings and usage

u.s.

Credit cards are an important fixture on the
financial scene because of the services they
provide businesses and households. Of the
different types of cards used in the U.s., those
issued by banks and retail stores account for both
the greatest percentage of cards held (nearly 70
percent) and the highest level of spending. Other
types of credit cards, such as gasoline and travel
and entertainment cards, are less widely
distributed and account for a significantly smaller
share of receivables.
The 1983 Survey of Consumer Finances, a
government-sponsored survey which included
approximately 3,800 representative U.s. families,

FRBSF
provides important insights into card use patterns
and the characteristics of card users. The survey
indicates both current use and the dynamic pattern
of adjustment to changes in credit card pricing.
Nearly two-thirds of all u.s. families hold at least
one credit card - a fraction that has risen slightly
in recent years. Moreover, there have been
important shifts in the types of credit cards held by
u.s. families because of basic changes within the
credit card industry. The imposition of annual fees
for bank cards in the early 1980s, for example,
resulted in a decline in multiple holdings of bank
credit cards. Today, fewer than 40 percent of U.s.
families hold more than one bank credit card, and
less than 10 percent hold more than two.
Consumers have also reduced their holdings of
gasoline credit cards as a result of the increased
acceptance of general purpose cards such as VISA
and MasterCard for gasoline purchases. Still, the
total number of both bank and nonbank cards held
and used has grown during the 1980s.
Relatively wealthy and educated individuals tend
to be the most frequent users of credit cards. For
example, the 1983 Survey reveals that more than
90 percent of families with annual incomes of
$50,000 or more reported regular use of their
credit cards. The usage rate is similarly high in
families in which the head of the household is a
college graduate. Usage rates decline steadily with
decreasing income and education, although this
decline is gradual and limited. The 1983 Survey
indicates, for example, that the usage rate is
approximately 50 percent even for families with
annual income as low as $10,000. Thus, all but the
poorest families appear to be active users of their
credit cards.

Implications of proposed legislation
The current controversy over the level of credit
card interest rates has stirred some Congressional
interest in establishing a national usury ceiling on
such charges. To date, three legislative measures
have been proposed. If enacted, these measures
would create a formula link between credit card
rates and either the discount rate (HR 1197), the
three-month Treasury bill rate (HR 3408), or the IRS
penalty rate (S 1922). Currently, these bills would
generate maximum allowable card rates of between 10 percent and about 13 percent - considerably below the national average of approximately 19 percent.

A nationwide usury ceiling on credit cards would
have the effect of lowering interest charges paid
by revolving debt users. It would also, however,
probably generate a variety of other secondary
effects that would adversely affect card issuers,
merchants, and all credit cardholders in general.
Given that about 60 percent of revenues of bank
card plans are derived from finance charges, a significant reduction in card interest rates would
undoubtedly reduce the profitability of bank cards.
As profits declined, card issuers could be expected
to attempt to reduce credit losses by rationing
credit. One likely response would be the imposition of stricter credit standards for new card applicants. Such a response, however, would paiticularly harm low income families by making it difficult
for this group to obtain a credit card.
Businesses that accept bank credit cards and their
customers could also be harmed by a usury ceiling.
If banks were to attempt to maintain pre-ceiling
revenue levels, they could choose to raise the
amount of the discount that merchants must incur
(typically 2-5 percent) when they present credit
card receipts to banks for collection. Ari increase in
the merchant discount would not only lower profits on retail credit card sales, it could also invoke
price increases as merchants attempt to regain previous profit margins. Such price increases could
also occur in the case of retailers that offer their
own credit cards.
Ironically, all credit card holders are also likely to be
adversely affected by a usury ceiling. This is
because the benefits of a usury ceiling - lower
interest charges - would be realized by only a portion of the cardholding public. Certain costs arising
from the imposition of such legislation, however,
are almost sure to be borne by all cardholders. Evidence from the 1983 Survey indicates that 47 percent of card users "nearly always" pay their outstanding monthly credit card balances in full and
thus incur no finance charge. An additional 26 percent (73 percent combined) "sometimes" pay in
full. Only 27 percent of the respondents indicated
that they "hardly ever" pay their monthly balances
in full and thus consistently incur a finance charge.
The direct benefit of lower interest rates, therefore,
would probably be realized by the less than half of
all card users that use their credit cards as a source
of revolving debt.

Credit Card Rate vs Other Interest Rates

fees, and more stringent credit standards.

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Additional costs
The additional costs imposed by the likely pricing
adjustments of card issuers, however, would be
borne by all cardholders, convenience and revolving de~t users alike. If revenues are reduced by
lower finance charge rates, card issuers are sure to
respond by trying both to raise revenues in new
ways and to cut costs. To raise revenues, banks
and retailers could alter the billing cycle used to
calculate interest charges, shorten or eliminate the
interest-free grace period, or impose late fees and
service fees. In addition, banks could raise annual
card fees and reduce the value of enhancements
(such as travel insurance and card registration services).
Two other comments seem relevant. First, it is not
clear that a usury ceiling is needed to ensure the
availability of lower interest credit card plans. At
least one industry newsletter and, more recently, a
Congressional sponsor of HR 3408 have provided
~vidence of numerous card plans that stipulate an
Interest rate below that of the national average. In
some cases, the interest rate charged was as low as
13 percent, or about six percentage points below
the current national average. Such data would
se.em to suggest that lower credit card rates are
already available to those cardholders for whom
the finance charge is an important consideration.
Of course, prospective cardholders would be wise
t? consider all aspects of any particular card plan
since many of these low-interest credit cards
feature shorter grace periods, higher annual card

Furthermore, it is likely that a national usury ceiling
- especially one that is pegged to a variable
interest rate such as the three-month T-bill rate would create costly compliance and enforcement
problems for card issuers and regulators. Federal
law and some state laws require prior notification
of changes in credit card finance rates (some states
require more than one notice). In addition, some
states require that outstanding balances incurred
under the prior interest rate be maintained and
charged separately from those incurred under any
new rate. Thus, it is possible that during a period of
fluctuating interest rates, considerable effort and
~xpense would be incurr:d by cardholders, card
Issuers, and regulators to Implement and keep track
of segmented, multiple interest credit card
accounts.

Conclusion
The existence of two modes of use for credit cards
- convenience and revolving debt - indicates
that consumers differ as to which features of the
credit card product are important to them. Convenience users are likely to favor lower annual card
fees and car~ less about the level of finance charge
rates. Revolving debt users are more likely to be
concerned with finance charge rates and credit
availability than with annual card fees and
enhancements.
These different credit card holding and usage patte~~s suggest t~at the beneficial effects of a usury
ceding on credit card interest rates are likely to be
unevenly distributed. At best, only a portion of
card users would benefit since many cardholders
~re ~onvenience users and consistently avoid payIng Interest charges. More likely, a national credit
~ard rate ceiling would adversely affect the nonInterest aspects of credit card pricing for all
card~olders, a~d could reduce credit availability if
funding costs rise again. A usury ceiling could
restrict opportunities for consumers to make tradeoffs among finance charge rates, annual fees and
other terms of card pricing. There is evidence that
significant interest rate differences already exist
among card plans. Card users that are sensitive to
interest rates, therefore, might benefit more from
seeking out a low-interest card plan than from
usury legislation.

Anthony W. Cyrnak, Visiting Economist

Opini?ns expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Fr~nCl~co, or of the Board of Governors of the Federal Reserve System.
EditOrial c0',T'ments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtamed from the Public Information Department, Federal Reserve Bank of San Francisco POBox 7702 San Francisco
94120. Phone (415) 974-2246.
' . .
,

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Dailv Filmres
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed(-)

Amount
Outstanding
12/4/85

198,931
180,359
51,858
65,759
38,051
5,426
11,231
7,341
203,775
51,440
33,767
14,989
137,346

-

-

45,874
37,960
27,798
Period ended
12/2/85

68
148
79

Change from 12/5/84
Dollar
PercenF

Change
from
11/27/85

-

-

137
-

-

525
1,681

11,400
11,330
1,009
4,221
6,833
351
385
455
9,194
4,461
3,602
1,921
2,811

6.0
6.7
- 1.9
6.8
21.8
6.9
- 3.3
6.6
4.7
09.4
11.9
14.7
2.0

5,340

458
555
55
90
7
1
111
14
111
308
603
651
454

13.1

2,464
5,496

Period ended
11/18/85

40
19
21

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
1

2

-

6.0
24.6