Commentary on Credit Card Interest Rate Caps Legislation
Federalist Society expert Prof. Todd Zywicki has written several articles on the recent legislative momentum to cap credit card interest rates. His arguments explore a breadth of financial regulatory history and offers warnings for unexpected outcomes for consumers. Click the titles to read the full articles or read the summaries below.
Senator Bernie Sanders and Representative Alexandria Ocasio-Cortez proposed a law that would limit interest rates to 15%. Although they invoked the classical idea of loan sharks to prove their point, what they do not realize is that interest rate ceilings are directly attributed to an increase in loan sharks. Usury ceilings harm poor families by forcing them to opt for loan sharks rather than the traditional financial lending service. Low wages, unemployment, unexpected expenses, and the like translate to high loss rates. Moreover, costs of small loans are high, and to recoup that amount the effective interest rate on small loans are increased.
Low usury ceilings made it more difficult for poor families to borrow from legitimate lenders, thereby giving rise to the amount of loan sharks. In response to this rise in illegal and predatory loan sharks, consumer advocate groups demanded interest rate restrictions be loosened so they could compete with loan sharks. Eventually the loan shark business all but disappeared in the states where regulations were loosened and were replaced by legitimate personal finance and small loan companies.
After the Clutch Plague struck the nation, the regulations were tightened again and gave rise to an intense loan shark market. In fact, loan sharks lobby for unrealistically low rate knowing full well that those ceilings would allow them to charge astronomical rates. Adjusting for inflation, loan sharking was worth $69 billion annually. Of course, the well-known facts about loan sharks show that if they loans were not paid, $69 billion worth, there would be dire consequences. Between 1970 and 2000, after the Marquette decision, Americans with credit cards rose from 15% to 70%, and essentially rid loan sharks from society.
Usury ceilings and loan sharks are directly related, and history has demonstrated that these regulations bring a direct rise in loan sharking. The proposed regulations would put the exact benefited target, poor families, at a significant disadvantage, as has happened consistently in the past. The answer to the problem is not usury ceilings, it is deregulation.
Senator Kirsten Gillibrand proposed a plan, endorsed by Senator Bernie Sanders and Representative Alexandria Ocasio-Cortez, that permits the United States Postal Service to provide banking services, which is said to solve the financial exclusion of poor families and the issue of payday lending. However, the public utility model is less effective than competition and regulatory reform. The United States Postal Service previously offered small-dollar savings accounts. Sen. Gillibrand’s proposal goes much further, it allows check-cashing, money orders, remittances, checking and savings accounts, and small-dollar loans.
Banks make their money as a financial intermediary. Postal banks would not be able to do this through the proposal because it prevents postal banks from conducting “traditional banking activities.” It is suggested that the source of income would rise from small-dollar loans, but with the rate of defaults on payday loans are high and therefor presents an issue of how the post office will collect on their loans. Additionally, with the proposed 2.4% cap on interest rates, there is no accounting for operating cost or losses on defaults.
Furthermore, with the post office’s lack of long hours and pace of customer service in comparison with payday lenders would put them at a significant competitive disadvantage. To help mitigate this disadvantage, the government would have to protect them as a monopoly. However, even then there is no evidence to suggest it would help mitigate losses; the post office loses billions of dollars annually while owning a monopoly on first-class mail delivery. The only reasonable option, admitted by the post office, is partnering with private companies.
The best solution is to deregulate the financial services market to allow more competition. Walmart, for example, offers a variety of limited financial services, including but not limited to check cashing and money orders at flat rates. They succeed by being 24 hours, reaching a larger segment of the market. By allowing retailers to seek bank charters, the financial services market would see a significant positive impact for consumers. Competition, not government sponsored monopolies, is the solution to fix the problem of the financial exclusion of poor families.
Sen. Bernie Sanders and Rep. Alexandria Ocasio-Cortez are proposing a national interest-rate ceiling of 15% on all consumer credit products to help poor families. However, this proposal hurts everyone else who pays their monthly balance. One way this hurts others is through the increase in the price of products from retailers to offset the losses from their credit operations. This is demonstrated through the increase in price of products in states with more restrictive usury ceilings than states without less restrictive usury ceilings.
The proposal from Sanders and Ocasio-Cortez outlaws lenders of last resort; personal finance company loans, pawn shops, etc. This has the effective of forcing poor families to use loan sharks to get credit for the goods they need. By raising or eliminating the interest rate ceilings, poor families have more choice. Marquette National Bank v. First of Omaha Services Corp., 439 U.S. 299 (1978) held that usury ceilings for federally chartered banks is issuing bank’s state law, not the customer’s. As a result, credit card operations moved to states where rates on credit cards are set by markets rather than politicians.
After the elimination of such usury ceilings there is more competition in the credit card market, leading to more poor families gaining access to credit cards, annual fees being eliminated, and more rewards systems. These positive outcomes would disappear under the proposal by Sen. Sanders and Rep. Ocasio-Cortez; small businesses would no longer be able to compete with larger businesses who can afford the negative financial impact of interest rate ceilings, and as such the access to credit cards would be minimized once again.
The proposal does not acknowledge the fact that the remaining consumers with credit cards would bring back all the conditions of credit operations that were previous eliminated through a free market. Annual fees will be reinstated, there will be less rewards, more pawn shops, and a return of loan sharks
Federalist Society’s Financial Services & E-Commerce Practice Group