Submission to the Senate Inquiry into Matters Relating to Credit Card Interest Rates

Credit cards as sources of credit

Credit card debt

Each month, cardholders receive statements of their use of credit for transactions over the previous month. For a cardholder who has paid off their previous balance in full, credit cards typically offer an interest-free period of up to 55 days on new transactions, given that the cardholder typically has about 25 days following the end of the statement period to repay the statement balance. If the balance is not paid off in full, interest becomes due from the date of each transaction (and the cardholder will not benefit from an interest-free period the following month).

In the June quarter of 2015, new credit card transactions averaged around $24 billion per month. At the end of June, the total level of credit card debt was $51.5 billion (Graph 11). Of this amount, $33.1 billion, or around 65 per cent was bearing interest. A simple calculation would suggest that around 75–80 per cent of transactions on credit cards do not accrue interest. That is, interest-paying ‘revolvers’ account for about 30–40 per cent of accounts, about 20–25 per cent of transactions, but close to two-thirds of the outstanding stock of debt.^[9]

The proportion of the stock of debt that accrues interest has fallen from around three-quarters of balances in 2012. Balances accruing interest have also fallen in absolute terms after peaking in late 2011 (Graph 11). This decline possibly reflects a range of factors such as changes in consumers’ financial behaviour, government reforms in 2012 relating to repayments and limit increase arrangements, and possibly also the effect of competition for balance-transfer offers.

More broadly, credit card debt has represented a declining share of household borrowing over the past decade. Credit card debt peaked as a share of household debt at around 4½ per cent in 2001 but now represents a little below 3 per cent of household debt. While the ratio of overall household debt to income has been relatively steady over the past decade, the ratio of credit card debt to household income has declined (Graph 12). The decreased share of credit card debt may partly reflect the high cost of credit cards relative to mortgage interest rates and the increasing ability of households to use mortgage offset and redraw facilities as a source of low-cost funds. These products have become increasingly common over the past decade or two, with most loans now including such a facility (see RBA (2015b)). The amount available under these facilities has grown from less than 10 per cent of household income in early 2008 to over 20 per cent of household income (or around $220 billion) in mid 2015.

Credit risk to banks

There is relatively limited information available on the risk of credit card lending. Data reported to APRA indicate that the non-performing loan (NPL) rate on banks’ credit card debt (defined as where repayment is more than 90 days past due or otherwise doubtful) has increased gradually during the past decade, although it has declined slightly over the past couple of years. The credit card NPL rate stood at 1.5 per cent as of early 2015, which is lower than the comparable ratio for other personal loans.

However, the overall loss rate for credit card issuers is probably higher than suggested by the NPL rate. Unlike some other types of household loans such as residential mortgages, credit card loans are unsecured, with little prospect, in some cases, of recovering a significant portion of the debt if the borrower defaults. As a consequence, some credit card debt may be written-off directly to an issuing institution's profit and loss account, without first being recorded as a non-performing loan.

Data from the financial statements of three major banks suggest that the overall loss rate on their credit cards has been falling over the relatively short five-year period for which the data are available, and stood at 2.5 per cent as of early 2015 (Graph 13).^[10] This loss rate represents an average calculated over all users of credit cards; it is reasonable to assume that banks’ risk models expect lower loss rates for some account holders and higher rates for others, for example borrowers who have tended to be revolvers.

Interest rates on credit card debt

There is significant variation in the advertised rates on credit card debt, reflecting the wide range of products offered, but some bunching of standard cards around 20 per cent and around 13 per cent for lower-rate cards (Graph 14).

The Bank publishes data on average advertised credit card interest rates for ‘standard’ and ‘low-rate’ cards. Since around 2010 the average interest rate for standard cards has been fairly steady at just under 20 per cent, while for lower-rate cards the average interest rate has been about 13 per cent (Graph 15). These data are average advertised (ongoing) interest rates rather than the average interest rate actually paid by all holders of standard or lower-rate cards. For instance, the relatively stable advertised rates in recent years do not take into account low- or zero-rate balance transfer offers that cardholders may receive for switching their outstanding credit card debt to another bank.

Consequently, average interest rates paid may be lower than the advertised ongoing rates, to the extent that cardholders have been switching banks to take advantage of these deals. More generally, the advertised interest rate on a card is only relevant to those cardholders who do not pay off their monthly statement in full and have a stock of outstanding debt.

Data collected by APRA from the major banks provide some further information on actual interest rates on their credit card portfolios (Graph 16). These data indicate that the actual average interest rate on the entire book of credit card loans (including debt that does not yield interest) was 11.6 per cent in the March quarter. While advertised credit card rates have been little changed in the recent period, the effective interest rate received by banks on their entire credit card portfolio has fallen by close to 2 percentage points since mid 2011. The effective interest rate on the entire credit card portfolio does not, however, provide a guide to the experience of those cardholders who pay interest on their credit card debt. Based on data reported reported to the Bank showing that around 35 per cent of outstanding credit card debt did not bear interest, the effective average interest rate for those borrowers that pay interest is estimated at about 17 per cent, down about 1 percentage point from 2011. Taken together, the recent changes in these two series are consistent with the observed decline in the proportion of the stock of debt that is accruing interest (either reflecting more consumers paying down debt ahead of being charged interest, or reflecting an increase in the take up of zero-and lower-rate balance transfers) and also some switching by consumers from high- to lower-rate cards. The major card-issuing banks would be able to shed further light on these estimates.

Based on estimates of the overall cost of funds for banks, it is possible to calculate the spreads on different lending rates (Graph 17).^[11] The data indicate that the interest rate on bank credit card portfolios is around 9 percentage points above the cost of funds, while the spread for those borrowers who are paying interest is about 14¾ percentage points. These spreads rose significantly in the global financial crisis (when funding rates fell significantly but credit card rates fell by much less) and have remained at that level or drifted modestly higher since.

The observation that issuers compete actively for customers yet credit card interest rates are high and do not closely follow changes in funding costs is consistent with international experience and has been studied by academics. The most well-known paper addressing this issue is a study by Ausubel (1991) for the United States. The study notes the apparent paradox that a market with few barriers to entry and the presence of 4,000 competitors could be characterised by very sticky interest rates and card issuers making much higher rates of return on their credit card lending than on other lines of business. Based on the work of Ausubel and others, it seems reasonable to explain the apparent paradox as resulting to a large extent from the existence of a significant number of consumers who are either not well informed or (for various behavioural reasons) are reluctant to switch banks or seek a lower rate. At the same time, banks may have little incentive to lower interest rates, given that rates are not a determining factor for many individuals who may (possibly mistakenly) not expect to build up significant balances, while in the case of other individuals, banks may worry that lower rates may attract lower-quality borrowers.

Footnotes

The Bank does not have data on the distribution of account balances. However, the average balance across all 16 million accounts is around $3,200. On the assumption that around 30 to 40 per cent of all accounts accrue interest, the average balance outstanding on those accounts would be around $5,000 to $7,000, and the implied average balance for those accounts that do not accrue interest would be around $1,600 to $1,900. [9]

For a broader discussion of credit losses at Australian banks, see Rodgers (2015). [10]

The Reserve Bank constructs aggregate estimates of banks’ funding costs using measures of the cost of various deposit and wholesale funding sources and weighting them by their share of total bank funding. While these are the Reserve Bank's best estimates, there remains a degree of imprecision around them. For more details, see Tellez (2015). [11]