How banks take advantage of 'deluded optimists', keep credit card rates high, set honey traps, and confound regulators

By David Chaston

On Thursday, September 22, 2016, newly appointed Reserve Bank of Australia Governor Philip Lowe was asked this question in his appearance before the Australian Parliament’s economics committee:

“Why are credit card interest rates as high as 20% plus even after official interest rates have fallen to record lows?”.

The question is not unique; it has been asked many times of others.

But his answer was unique: Lowe said he did not know.

“I wish I knew the answer to that”, he is reported as saying.

“If you ask the same questions in your subsequent hearings, I will be interested in the answers,” Lowe added.

He is referring to the same Australian committee’s role in quizzing the CEOs of their four pillar banks. They will each separately appear before this committee next week for a four hour individual grilling, an event that will become an annual one on their calendar.

The credit card question is sure to be raised.

What about in NZ?

It is equally relevant on this side of the ditch. Last year Commerce and Consumer Affairs Minister Paul Goldsmith and the Commerce Commission made it clear they either won’t or can’t do anything about high credit card interest rates.

In the past, when the benchmark OCR went up, credit card interest rates went up by a similar amount. Banks claimed credit cards were funded at rates based on the 90 day bank bill rate.

And when they went down, those same interest rates tended to slide back as well, maybe with a small lag.

But since 2012, that changed.

Credit card rates did not respond to falling wholesale rates.

We will be watching those Australian hearings carefully for the explanations given by the bank bosses.

Margin swells

Meanwhile, back in New Zealand, the margin between the “weighted average interest rate on interest-bearing advances” on credit cards as revealed in the Reserve Bank of New Zealand data series C12, and the 90 day bank bill rate (RBNZ B2) has grown to its highest level since these records began.

And that comes as the wholesale benchmark has reached a record low.

Why isn’t competition working in the credit card market?

Clearly Philip Lowe doesn’t know, but would be keen to find out.

It is reasonable to suspect the RBNZ and Commerce Commission don’t know either.

Banks seem to have implicitly decided to not compete on price. Or maybe there are some quiet signals coming from the credit card interchange brands? It is hard to know, but clearly there are no price competitive instincts in this sector.

Deluded optimists

And the situation is not helped by customers.

About 40% of credit card customers pay their balances off on time, without incurring any interest costs.

However, that leaves a surprising number of users who succumb to these 20% interest rates.

They have been labelled as “deluded optimists” who believe they will pay their cards off on time. They’re not concerned about rates either because they falsely believe they won’t have to pay them. Psychological tests show the more likely people are to select cards with high rates, the more optimistic they are about life.

Banks focus their promotion of credit card benefits around ‘rewards’ and ‘low or no-rate balance transfer terms’.

Both are honey traps.

‘Rewards’ only work for the very disciplined, and usually come with cards that have a high annual fee.

Promotional ‘balance transfer terms’ are an even stronger honey trap. The benefit is real for the balance transferred, but any additional charges to the card attract the full interest rate. However, you also give up all interest-free days. It is this lack of interest-free days that most consumers don’t know about, and is the trap. It is very hard to make a balance transfer on to a new card at the promotional or zero rate, and then not use the card at all during the promotional period. If you do, the bank has gotcha.

This is how one bank explains it:

You can make new purchases and cash advances on the credit card you transfer an outstanding balance to. Both will incur the current standard purchase interest rates from the date the transaction is made with no interest free days.

This disclosure is there in full; it is just not in the promotion and certainly not in the customers mind when they sign up.

Effectively, as the RBNZ data shows, banks use slick marketing to take the focus off high credit card rates, make low promotional rates slip into high effective rates quickly, and bait clients with ‘rewards’ that come with high costs.

‘Deluded optimists’ think they can avoid these traps, but the data shows the extent of their delusion. Bank profits reinforce the delusion.