Credit-card industry faces uncertainty as reforms loom

Outlook for the credit-card industry as government reforms take shape? Uncertain.

Just 77 days after President Barack Obama signed the Credit Card Accountability Responsibility and Disclosure Act of 2009, and six months before it will take effect, credit-card issuers are scrambling.

They are seeking ways to keep making money in a bad economy with rising unemployment and credit-card defaults while preparing to implement major changes in how they deal with consumers.

In interviews, industry officials discussed the impact the act, which takes effect in February, will have on issuers:

The industry will have a lot less free rein to hike cardholder rates and fees.

It will have increased costs and lost revenue because of the reforms.

Many consumers will find it harder to qualify for credit cards at the most favorable terms.
“We can’t discuss the card business without addressing the elephant in the room of the recently signed industry law,“ Richard D. Fairbank, chairman of McLean-based Capital One Financial Corp., said at a recent investors’ and security analysts’ conference in New York.

It will clean up industry practices and lead to a reinvention of the industry, he said.

While the legislation contains provisions he would have preferred not to see, “overall it will play to Capital One’s strengths,“ Fairbank said.

Rates and risk
Perhaps the most costly of the changes, from the vantage of the card issuers, will be a ban on the practice of raising rates on existing balances, except in certain instances. It is called re-pricing.

A related pricing practice that will bite the dust is their ability to raise cardholders’ rates if they mess up with another creditor.

The act also will restrict interest rate increases during the first year after a credit-card account is opened, with some exceptions.

“In the aggregate, these provisions make it harder to manage risks,“ said Kenneth Clayton, senior vice president and general counsel of the American Bankers Association’s Card Policy Council. Credit-card transactions “are the riskiest loans you can make,“ he said, because there’s no collateral backing the transactions.

If issuers are deprived of tools to assess risk, it becomes riskier to extend credit to borrowers, some of whom will wind up defaulting, industry officials said. And defaults erode the profitability of credit-card operations.

Capital One, the largest independent U.S. is suer of credit cards and one of the largest employers in the Richmond area, changed the way the industry operates by using risk-based pricing.

Instead of charging everyone the same interest rate, Capital One offered its lowest rates to people considered the best credit risks and its highest rates to people more likely to default.

Capital One’s pricing for risk always has been a powerfully competitive advantage, Fairbank said.

“But the widespread use of some of the soon-to-be-banned industry practices diminish the power of that advantage,“ he said. “Now that the new law has effectively ended these practices, our competitive advantage in up-front underwriting and pricing for risk may once again be a key differentiator as it was for us in the’90s.“

The transition will be rough as the industry adjusts to the new rules, Fairbank said.

“What that’s going to do across the board is encourage all banks to offer cards only to the best credit risks,“ said Steve Verdier, senior vice president of Congressional Affairs at the Independent Community Bankers of America, a trade organization.

“There are concerns that the legislation will mean fewer people will be eligible for credit cards and that those who do have cards will receive less favorable terms than they enjoyed before,“ said Jay Spruill, general counsel at the Virginia Bankers Association.

Morningstar analyst Matthew Warren said the industry likely will try to find new tools for assessing risk. “One of the key tools was raising customers’ interest rates,“ he said.

Consumer advocates say the changes will force more consumer-friendly risk-management techniques.

Travis Plunkett, legislative director of the Consumer Federation of America, said the new law gives credit-card issuers the opportunity to be more responsible as to whom they loan money to and how much of a loan they offer.

“We said all along that we prefer credit-card companies use responsible risk-management techniques, such as if someone gets into trouble, don’t extend more money to them instead of doubling and tripling their rates,“ Plunkett said.

Consumer disclosure
Another reform provision would require issuers to vastly improve their disclosures to consumers by making them simpler, clearer and more informative.

Issuers will have to put on each monthly statement, for example, how much in fees and interest cardholders have paid year-to-date, and the true cost of their debt and how long it will take to repay it if they pay only the minimum.

“For a credit-card company to change the way it does its billing requires huge changes in its computer system,“ ABA spokeswoman Carol Kaplan said.

“It will be costly,“ said Michael Kon, senior analyst for Morningstar in Chicago. No one is hazarding a guess yet on how much.

Ultimately, the costs are passed on to customers, Kaplan said. “The real losers here are the consumers.“

Payment allocation
Another industry practice that will bite the dust in February and cause lost revenue for issuers is payment allocation.

Say a consumer has a credit card with three interest rates: one rate for a balance transfer, another for subsequent purchases, a third for making cash advances.

Generally, issuers apply the consumer’s payment to the lowest interest balance, leaving the high-interest balance racking up the most lucrative interest income.

When that goes away in February, “you have a reduction in the amount of interest that will be paid on the account,“ Clayton said.

Payments will have to be allocated to the highest rate balance first.

New frontier
Consumer advocates say the credit-card industry brought its woes upon itself.

“We know these reforms will be costing money, plus it’s a terrible time in the economy,“ said Linda Sherry, deputy director of Consumer Action. “But it’s very hard for us consumer advocates not to say, ‘You’ve made your bed, now you’ve got to lay in it.‘“ In the industry’s favor, the law does not cap all rates or fees, or stop an issuer from introducing new higher-rate products or from imposing annual fees.

Also, issuers have another six months of freedom to continue the practices that prompted the legislative restrictions.

“I think these companies have to stop relying on the status quo and get to work finding new ways of doing business that perhaps will create consumer loyalty while building their revenues back up,“ Sherry said. “Going forward, they will have to build up more innovative ways of doing business through the fair treatment of consumers.“