Regulation and Credit Woes

Representatives and appointees in the federal government – including the Federal Reserve – supposedly are quite concerned about a credit crunch and the negative implications for the economy in general.

If that is the case, then why has the Federal Reserve just put forth various regulations on credit card issuers that look destined to raise credit costs and reduce access to credit?

The Fed has put forth a set of requirements that dictate how credit card issuers operate and price their services. Some of these measures sound quite appealing. But, in general, this government intervention into the marketplace comes with potentially serious costs.

Consider several points made in a November 30 report by Meredith Whitney, Joseph Mack and Kaimon Chang titled “Consolidated Lending Market Poses Risk to Overall Consumer Liquidity” from Oppenheimer:

• The authors are “beginning to see evidence of broad-based declines in overall consumer liquidity.”

• Part of this story is increased regulation: “We believe that by restricting a lender’s ability to price for risk and significantly altering the economics of the credit card industry, lenders will ultimately choose to provide fewer credit lines to fewer customers. In fact, … we expect over $2 trillion in outstanding lines to be reduced over the next 18 months.”

• The authors are concerned about an unprecedented combination hitting the economy: “We view the credit card as the second key source of consumer liquidity, the first being their jobs. Pulling credit at a time when job losses are increasing by over 50% year on year in most key states is a dangerous and unprecedented combination.”

• With the Unfair and Deceptive Acts or Practices proposals, the authors note “that the regulators believe they are actually doing what is best for the consumer, but we argue that the ‘unintended consequences’ of such actions will at least do a commensurate amount of harm to the economy by stifling consumer spending… Due to an inability to maintain pricing flexibility on unsecured loans, we believe there will be a dramatic reduction of risk taking and therefore credit lines outstanding. This line reduction will strain credit quality not just for credit card loans, but, in our opinion, for all consumer loans.”

• The authors compare this regulatory scenario to what recently happened in Japan: “We believe what happened in Japan related to the change in Grey Zone laws provide an informative proxy of what to expect in the US if our regulatory timetable remains ‘as is.’ In December 2006, Japan passed a series of laws setting the maximum interest rate lenders can charge to a range of 15% to 20%, down from what had been over 29%. In addition to these restrictions, moneylenders could face criminal sanctions if they charge rates over 29.2%. What happened as a result of the reduction in lenders’ ability to set their own prices (however unfair they may or may not have been) was a dramatic contraction in lending by those lenders.” The fallout included lenders going bankrupt and some firms exiting the business, with a reduction in liquidity for Japanese consumers.

No one should be surprised when government regulation generates unintended, sizeable costs.

Raymond J. Keating
Chief Economist
Small Business & Entrepreneurship Council