Risk-Based Pricing's Demise Due to the CARD Act

Wondering why your credit card rates have gone higher in the past year? Wondering why your credit card line has been cut? Wondering why your bank canceled your credit card? Well, thank the US Congress for the unintended consequences of the CARD Act.

The result of CARD ACT has been a gradual shift in overall credit card rates over the past year. The 14.7% average credit card rate for the 2nd quarter 2010 is up from 13.1% a quarter ago and represents the highest rate of interest charged in 9 years. The spread between the Prime rate and the average card rate is also the highest in 22 years. http://www.huffingtonpost.com/2010/08/23/credit-card-rates-expecte_n_690939.html

Issuers of credit have long used the concept of risk-based pricing. When credit lines are issued, they are risk-rated across the type of debt, collateral, and borrower.

Whenever a customer borrows and puts up collateral, that credit line is risk-rated "lower" than a loan that has no collateral behind it. The reason is that the bank who lent the money can take back the collateral and sell it to recoup some of its losses. A mortgage is a great example of a collateralized loan '" the bank forecloses and sells the home to try to collect the balance owed and cover its costs. A car loan is another example of a collateralized loan but what makes a car loan more expensive than a mortgage is, in part, because a car is a depreciating asset. Once the buyer drives off the car lot, the car is worth less than it was new. Then, over time, a car adds miles and wear and tear. If a car loan goes to repossession, the loan balance may be more than the car is worth, so the higher interest rate allows the bank to make profits it can use to set aside as a loan loss reserve to help offset the overall deficiencies between car loan balances and sales of the cars at the repo lot.

Credit cards previously allowed the bank/issuer to adjust the interest rate as the borrower's risk profile changes. The issuer periodically checked the cardholder's credit score for changes, for example. If the cardholder's credit score changed due to additional debt and higher balances on other credit cards, for example, the issuer raised the rate on the card issued to the borrower so that more interest was charged and collected, and reserves were increased for potential losses. The borrower appeared to be more risky and therefore the issuer believed that the borrower presented a higher risk of default. The ability to re-price the credit card over the life of the relationship also allowed the issuer to take more risk with the borrower in the first place. If the borrower was young and had a "thin" credit file (not a lot of debt history per the credit bureau), the issuer might be uncertain about the borrower's credit discipline. How might the cardholder react to the next recession, how timely will the cardholder be with his/her payments, how large a balance might the cardholder maintain? As the relationship continues, the issuer has a good idea of these behaviors and could fine-tune the credit line and interest rate on the card. The issuer might put the cardholder on a list for a rewards card or offer an additional card.

No one is disputing that card issuers also made a lot of profit from the various fees charged for over-limit spending, late charges, and interchange (fees charged retailers for card acceptance/use). While Congress found these fees to be excessive, the fees did go to fill the coffers in the case of loan loss reserves. And yes, banks manipulate their loan loss reserves all of the time in order to create profits (through the release of reserves) and to manage a particularly profitable period by increasing reserves. The reality is that while banks have long abused the rules for profits' sake, the ability to re-price their individual card relationships "on-the-fly" did allow the issuers to take more risk.

The unintended consequences of the CARD Act has been painful for many consumers. The pendulum swung too far in legislating the practice of risk-based pricing for credit cards such that banks, at this time, are unwilling to take as much risk as before. Many consumers have been hurt and have seen their source of credit reduced.