Among politicians and the public, there seems to be bipartisan support for a credit card interest rate cap (at 10%). Almost everyone is in favor of free stuff—why not zero rates—but there is no free lunch.
Below are two graphs from FRED showing credit card charge-off for the top 100 banks (CORCCT100S) and banks outside the top 100 (CORCCOBS), respectively. Let’s assume that anticipated losses rates are like recent ones—about 4.0% and 9% of balances, respectively—and not like the worst rates seen in the Great Financial Crisis (GFC), especially for big banks.
Credit Card Charge-Off Rate for Top 100 Banks (CORCCT100S)
Source: FRED Economic Data
Credit Card Charge-Off Rate for Banks Outside Top 100 (CORCCOBS)
Source: FRED Economic Data
According to the Stern School of Business at NYU, the (average) weighted-average of capital for banks is around 5%. Adding 5% to the 4.0% and 9% loss rates get you to required rates of 9% and 14%, already.
| Base Scenario (5% cost of capital) | ||
| Top 100 Banks | 4.0% + 5.0% | = 9.0% |
| Smaller Banks | 9.0% + 5.0% | = 14.0% |
For most banks, cards tend to be their riskiest portfolio; so, one would expect the hurdle rate to be substantially higher than average, if it’s, say, 7%, we reach break-even interest rates of 11% and 16% in good times. (Ahh, if only we had only good times.)
| Realistic Scenario (7% hurdle rate for credit cards) | ||
| Top 100 Banks | 4.0% + 7.0% | = 11.0% |
| Smaller Banks | 9.0% + 7.0% | = 16.0% |
Now, we’re ignoring many aspects of credit cards, like the types of borrowers—revolvers, who keep balances, or transactors who pay-in-full each month—and sources of revenue—big ones like transaction fees and late fees—as well as all non-interest expenses: operations, marketing, rewards, processing, etc. (See this note from the Fed for a detailed analysis, but remember that analysis’s time frame doesn’t include a deep recession or crisis.)
Based on the note, let’s increase revenue by 100 basis points (bps), which is kind of generous, so we’re now at required interest rates of 10% and 15%, respectively.
This means that, on average, large banks would break-even IF (and that’s a big IF) there was no downturn, but small banks would be 500 bps below their hurdle rate on average, even without a downturn. If loss rates returned to Crisis levels, the big banks would be about 750 bps below their required return.
We have a hunch—just a hunch—that most banks wouldn’t like to destroy that much shareholder wealth. Ergo, lots of people will lose their credit cards. (Some estimates are 90% of accounts would be closed.) That won’t be good for those cardholders or anyone else, and that seems like it might—just might—have broader, negative implications.
If you disagree, we’re happy to borrow any amount of money from you, for a long, long time, at a zero percent interest rate. Heck, we can even make the rate negative, if you want.