Credit card companies need to penalize bad behavior with outrageous fees to keep credit affordable for the rest of us, right? Yeah, not so much. Credit Slips blogger and Georgetown Law Professor Adam Levitin argues that risk-based pricing is a myth that credit card companies exploit to escape well-deserved government regulation.
As an idea, risk-based pricing isn’t all that bad: consumers pay for credit based on their risk. But with credit cards, only interest rates and late fees are arguably “risk-based.”
Interest rates are a terrible way to counter risk. Responsible cardholders never carry balances, so fiddling with their interest rates mean nothing. Kicking consumers with retroactive penalty APRs means that creditors failed to properly assess the risk in the first place; if creditors were truly risk based, they would respond to increased risk by slashing credit lines.
Late fees are equally terrible. Most creditors have three tiers of late fees. It doesn’t matter if you’re late by one hour or one month, even though the two clearly show different degrees of risk.
Or as Levitin puts it:
Suffice it to say that it is a real stretch to say that credit card pricing overall is risk-based; certain elements of card pricing are partially risk-based, but many are not. Moreover, there is no empirical evidence connecting the advent of risk-based pricing to lower costs of credit to creditworthy consumers or greater credit availability to subprime borrowers. There is a study that correlates late fees and overlimit fees with banks’ aggregate cardholder risk, as well as with banks’ market power, but there is no research connecting fee levels, which are often one-size fits all, with individual cardholder risk. The putative benefits of risk-based pricing depend on pricing being sensitive to individual level, not aggregate level risk, so that low risk cardholders don’t subsidize high risk cardholders.
In any case, the benefits that the card industry attributes to risk-based pricing are explained at least as well by other factors: lower costs of funds explain lower interest rates to creditworthy consumers (issuers’ annual net interest margin has been fairly static for the last two decades), and securitization is at least as good of an explanation for the expansion in subprime lending.
So why do credit card companies pretend to use risk-based pricing? To evade government regulation. Professor Levitin makes a convincing six-point case for the government to lasso creditors with powerful regulations, but we’ll let you read the full paper for yourself to see why.