The argument for this bill, as presented in Sanders' op-ed piece in Medium, is that credit card debt has never been higher, and the credit card companies are making an "exorbitant amount" on credit card interest ($178 billion in 2018). For Sanders, modern-day loan sharks are not those who work in the criminal underworld, but rather those who work on Wall Street collecting interest rates on credit cards. That is not a hyperbolic description. That is the introduction paragraph of his op-ed piece.
Sanders then goes on to invoke Dante's The Divine Comedy and proceeded to cite a 1980 piece of legislation that enacted a 15 percent credit card interest rate cap on credit unions, which he thought worked quite well, although the legislation has allowed for the National Credit Union Administration to bypass it. Sanders showed an additional disdain for payday lenders that charge an average interest rate of 391 percent, a service that disproportionately affect the African-American and Hispanic communities. Essentially, Sanders wants to "create a financial system that works for all Americans," and to "stop financial institutions from charging outrageous interest rates and fees."
Sanders really wants to stop predatory lending and make sure that Americans are not consumed by credit card debt. At least his heart is in the right place. Like with so many of his proposals, I have to ask the question of whether there are good results to match the good intent.
Economics of Interest Rate Caps
Proponents of credit card interest rate caps believe that the financial market functions differently than other markets because people need access to credit in order to live a good life. While I believe that access to credit is important, it doesn't automatically necessitate a solution, and it doesn't mean that the credit card industry is different in market functionality. When I discussed student loans in 2013, I explained the purpose of an interest rate, i.e., how interest is the cost of borrowing money. Every business has a product or service. For a bank, its business is money, both the investment of its customers' bank deposits and the loans the bank issues. A credit card company is also a lending institution, and is similarly subject to the supply and demand of money. Consumers make choices on the supply and demand of money, just like they do with any other good and service.
With that being said, how does the interest rate cap function? In economic terms, the interest rate cap is a price ceiling. To quote Milton Friedman from his book Free to Choose (p. 219):
Economists may not know much. But we know one thing very well: how to produce shortages and surpluses. Do you want a shortage? Have a government legislate a maximum price that is below the price that would otherwise prevail.
Standard microeconomic theory therefore suggests that demand for loans would exceed supply, assumedly because there would be enough lenders that would not want to loan money [to high-risk borrowers] at such low rates. How does the economic theory play out in practice?
Interest Rate Caps and Usury Laws in Practice
Usury laws are nothing new. As the Mercatus Center points out in its analysis on the arguments made by interest rate cap advocates (worth the read if you want more detail on the topic), such laws are the oldest and most tried government intervention in financial markets. Let's forget for a moment that payday loans have lower annual percentage rates (APR) than overdraft fees and bounce checks (Summers, 2013), that payday loans are short-term loans (hence the higher APR), payday loans do not adversely affect credit score (Bhutta et al., 2015), or that customers generally know what they're getting into when they take out a payday loan (e.g., Durkin et al., 2014; Elliehausen et al., 2001). Let's see what usury laws similar to the Loan Shark Prevention Act look like in practice.
After the Great Recession began, Congress passed what is known as the Durbin Amendment. The Durbin Amendment put a cap on the fees that could be charged for using debit cards. This was done in order to lower consumer burden in terms of consumer cost. Did it help consumers? No, not really. Instead of debit fee income, the banks instead opted to charge new fees on the bank accounts and raised the minimum balances required on bank accounts, as a Penn State University research team discovered (Mukharlyamov and Sarin, 2019). Not only did the Durbin Amendment shift more people from debit cards to more expensive credit products (i.e., credit cards), but it made one million Americans unbanked, thereby limiting their access to the mainstream credit system (Zywicki et al., 2014).
The phenomenon of making up the loss of the lower interest rate is not confined to debit cards. It has played out in the auto loan industry, as a working paper from the Consumer Financial Protection Bureau [CFPB] illustrates (Melzer and Schroeder, 2017). In the case of the auto industry, it did not restrict loans per se. What happened in the auto loan industry was two-fold. Although auto dealer lenders issued similar monthly payments, they compensated for the loss induced by the usury lawny raising the mark-up on the product sale instead of the loan interest rate. Second, higher-risk borrowers who borrowed from non-dealers received lower interest rates, but also received smaller loans relative to the collateral, i.e., they had restricted access to credit.
Shifting the costs to make up for profit loss did not only happen in the auto industry. In 2015, a federal court issued a ruling that voided usurious loans (i.e., no obligation to pay on the principal) in New York and Connecticut. The good news was that there was no evidence of strategic default. However, a look a secondary markets found that investors priced the increased legal risk about the usury amount when a borrower is late on payments. It was also found that credit availability for risky borrowers decreased significantly (Honigsberg et al., 2016).
In Ohio, a de facto payday loan ban resulted in the proliferation of pawn shops (Ramirez, 2019). Why? Because the demand for these financial products doesn't disappear with the cap. In the case of Ohio, it simply incentivized people to sell valuable possessions to get access to that money. Arkansas had a similar story in the 20th century. Not only did Arkansas have a spike in pawn shops, but small loan credit was not readily available and many consumer finance companies stopped operating in Arkansas (Peterson and Falls, 1981).
Conclusion
As hard as lawmakers have tried, it is very difficult to eliminate the concept of interest. We see one of two main unintended consequences take place. One is that high-risk borrowers have their access to loans and credit limited, thereby isolating them from the mainstream credit system (see Zinman, 2008 as an example). The second is that lenders add clever elements within the loan deal in order to keep within the letter of the law while making up for the financial loss caused by the interest rate cap, as we saw with debit cards and auto loans (i.e., borrowers, especially high-risk ones, are de facto paying [close to] the same price in either case).
Much like with rent control or minimum wage laws, a credit card interest rate cap would simply hurt the people advocates are purporting to help. A very generous best-case, but nevertheless improbable, scenario of the Loan Shark Prevention Act is that it would do nothing to improve credit access for millions of Americans. The worse and more likely scenario is that credit will be more difficult to access, and that financial hardship will increase for a number of economically disadvantaged individuals. I hope that the American people can escape these jaws of death by not having Congress pass the Loan Shark Prevention Act.
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