U.S. Credit Card Industry: Competitive Developments Need to Be Closely
Monitored (Chapter Report, 04/28/94, GAO/GGD-94-23).

Credit card interest rates in the United States hovered at about 18
percent for years despite wide fluctuations in the amount that lenders
paid for money that they loaned out, known as the "cost of funds." The
wide spread between the cost of funds and average credit card interest
rates since the late 1980s has reignited congressional concern about the
adequacy of price competition among credit card issuers.  This report
reviews the (1) assessments of whether the industry's structure supports
competition, (2) explanations that have been offered for the credit card
industry's relatively stable interest rates and high earnings, and (3)
proposed interest rate cap or other policy options.  GAO concludes that
a nationwide interest rate cap could lower the cost of credit card
borrowing for some cardholders, but it might also prompt the
cancellation of cards and restrict credit for cardholders who present
higher default rates.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-94-23
     TITLE:  U.S. Credit Card Industry: Competitive Developments Need to 
             Be Closely Monitored
      DATE:  04/28/94
   SUBJECT:  Lending institutions
             Interest rates
             Credit
             Credit sales
             Consumer protection
             Debt
             Competition
             Collusion
             Monopolies
             Data collection operations
IDENTIFIER:  VISA Credit Card
             MasterCard
             Diners Club Card
             Sears Discover Card
             American Express Card
             
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Cover
================================================================ COVER


Report to Congressional Requesters

April 1994

U.S.  CREDIT CARD INDUSTRY -
COMPETITIVE DEVELOPMENTS NEED TO
BE CLOSELY MONITORED

GAO/GGD-94-23

Credit Card Competition


Abbreviations
=============================================================== ABBREV

  BCHA - Bankcard Holders of America
  HHI - Herfindahl-Hirschman Index
  ROE - return on equity

Letter
=============================================================== LETTER


B-255894

April 28, 1994

The Honorable Joseph P.  Kennedy, II
Chairman
The Honorable Alfred A.  McCandless
Ranking Minority Member
Subcommittee on Consumer Credit and Insurance
Committee on Banking, Finance and Urban Affairs
House of Representatives

The Honorable Jim Leach
Ranking Minority Member
Committee on Banking, Finance and Urban Affairs
House of Representatives

The Honorable Esteban E.  Torres
The Honorable Charles E.  Schumer
House of Representatives

This report responds to your requests that we assess the
competitiveness of the U.S.  credit card industry.  It discusses the
structural characteristics of the industry, explanations for the
stability of credit card interest rates, and the advantages and
disadvantages of various policy options such as an interest rate cap. 
We also provide recommendations to the Chairman of the Federal
Reserve on improving available data about credit card interest rates. 

We are sending copies of this report to the Chairman of the Federal
Reserve, the Attorney General, appropriate congressional committees
and subcommittees, and other interested parties.  We will also make
copies available to others on request. 

This report was prepared under the direction of Mark J.  Gillen,
Assistant Director, Financial Institutions and Markets Issues.  Other
major contributors to this report are listed in appendix III.  If you
have any questions, please contact me on (202) 512-8678. 

James L.  Bothwell
Director, Financial Institutions
 and Markets Issues


EXECUTIVE SUMMARY
============================================================ Chapter 0


   PURPOSE
---------------------------------------------------------- Chapter 0:1

Until 1992, credit card interest rates in the United States had
remained stable at about 18 percent for many years despite wide
fluctuations in the amount lenders paid for funds that they loaned to
their customers ("cost of funds").  The wide difference between the
cost of funds and average credit card interest rates since the late
1980s has reignited congressional concern about the adequacy of price
competition among credit card issuers.  In November 1991, the Senate
passed a measure that would have set a nationwide cap on credit card
interest rates, but the House of Representatives did not vote on such
a cap before the session ended. 

The former Chairman and Ranking Minority Member of the House
Subcommittee on Consumer Affairs and Coinage, the Former Ranking
Minority Member of the Committee on Banking and Urban Development;
and Congressman Charles E.  Schumer asked GAO to review the
explanations that have been offered for the stable credit card
interest rates and evaluate the merits of an interest rate cap and
other related policy options. 

GAO reviewed the (1) assessments of whether the industry's structure
supports competition, (2) explanations that have been offered for the
credit card industry's relatively stable interest rates and high
earnings, and (3) proposed interest rate cap and various other policy
options. 


   BACKGROUND
---------------------------------------------------------- Chapter 0:2

The U.S.  credit card industry consists of about 6,000 card issuers,
mainly banks, thrifts, and credit unions.  Increasingly, nonbank
corporations-- such as AT&T and General Motors--are also entering the
credit card industry by establishing contractual relationships with
existing card issuers.  Most of these credit card issuers belong to
the two card associations--VISA and MasterCard.  Although VISA and
MasterCard each provide a nationwide transaction processing system
for cards carrying their logos, issuers of those cards own
cardholders' accounts, set interest rates, and decide on other
pricing aspects of the cards. 

Use of credit cards in the United States has grown substantially
since the mid-1980s.  Between yearend 1983 and yearend 1993, total
credit card balances outstanding (the dollar amount of borrowings
owed by cardholders) quadrupled, rising from about $39 billion to
about $156 billion in constant 1982 dollars.  One reason credit card
lending increased significantly in the 1980s is that many states
relaxed or repealed long-standing laws that placed limits on the
interest rates that card issuers could charge to consumers.  This
effective deregulation of credit card interest rates encouraged card
issuers to offer cards to riskier customers who previously did not
qualify for them.  However, after growing at an average annual rate
of 15.5 percent between 1986 and 1990, outstanding card balances
increased by 5.1 percent in 1991 and remained flat in 1992 during a
period of slow economic growth.  Credit card balances increased by
12.4 percent in 1993 as the economic recovery strengthened. 

While credit card issuers' expenditures on funding costs as a
percentage of their average outstanding balances have fluctuated over
the past 18 years, from a high of 13.38 percent in 1981 to a low of
5.33 percent in 1993, credit card interest rates were generally
stable at about 18 percent until 1992.  Since that time, many
companies, including new nonbank industry participants like General
Motors, Ford, and General Electric, have offered variable-rate credit
cards with lower interest rates to many consumers, particularly those
who have good credit histories.  The number of cardholders with lower
interest rate cards increased substantially in 1992.  Average credit
card interest rates fell to 16.83 percent in 1993 as a result of the
increasing price competition among card issuers. 

To meet its objectives for this report, GAO analyzed available data
related to the performance of the industry and reviewed a variety of
studies that have been written in recent years on its
competitiveness.  GAO also discussed the industry's competitiveness
with Federal Reserve and Department of Justice officials, private
economists, industry officials, and consumer groups. 


   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

Many economists have analyzed the credit card industry's structure to
determine the extent to which it might have facilitated
anticompetitive practices.  These analyses have generally concluded
that the industry's structure provides for adequate competition among
credit card issuers.  However, an alternative viewpoint suggests that
the industry's structure may have certain characteristics that limit
competition.  Currently, there is no compelling evidence to either
confirm or reject this viewpoint. 

Differences between credit card lending and other consumer lending
help explain differences in their respective levels of interest rates
and earnings.  Unsecured credit card lending is riskier than secured
lending activities, and funding costs represent a relatively low
percentage of total credit card costs.  As a result, credit card
interest rates are less responsive to fluctuations in the cost of
funds than are interest rates for other forms of credit.  The
long-term stability of rates may also be explained in part by the
high demand for credit cards and the expanding economy of the 1980s
and consumers' lack of response to credit cards that offer lower
interest rates.  GAO believes that competitive developments in the
industry should be closely monitored and that the Federal Reserve can
assist Congress in its oversight role by (1) collecting and
publishing additional information and (2) commenting on recent
competitive developments in its annual report to Congress on the
profitability of the credit card industry.  The Federal Reserve is
considering plans to collect additional information on credit card
interest rates and plans to comment further on recent competitive
developments after this information is collected. 

A nationwide interest rate cap could lower the cost of credit card
borrowing for some cardholders, but it might also result in the
cancellation of cards and restricted credit for cardholders who
present higher default risks.  Various other policy options include
maintaining a nonintervention policy or strengthening disclosure
requirements. 


   GAO'S ANALYSIS
---------------------------------------------------------- Chapter 0:4


      WIDELY HELD VIEW OF
      INDUSTRY'S STRUCTURE FACES
      SOME CHALLENGES
-------------------------------------------------------- Chapter 0:4.1

Many analysts have concluded that the structure of the credit card
industry provides for adequate competition among card issuers.  The
industry has a large number of issuers, about 6,000, who set their
own interest rates and other pricing terms.  The industry's
concentration level, which is one measure of the degree of
competition in an industry, is modest, suggesting that the industry's
behavior should be quite competitive.  Moreover, most depository
institutions that wish to issue credit cards and compete with
existing issuers can do so by simply joining VISA or MasterCard.  To
date, the Department of Justice has not instituted proceedings
against any firm charging an antitrust violation in its credit card
operations. 

On the other hand, an alternative viewpoint suggests that, in some
ways, the industry's structure has contributed to the performance of
credit card interest rates and earnings.  One argument is that the
largest card issuers dominate the credit card industry and conform to
one another's interest rate and pricing decisions.  This may explain
why several issuers charged the same annual interest rate of 19.8
percent for several years despite decreasing funding costs.  However,
other analysts disagree that the largest issuers control a sufficient
percentage of outstanding credit card balances to dominate the
industry in this manner. 

VISA and MasterCard have also been subject to antitrust complaints
that, for the most part, they have successfully fought in the courts. 
In a private antitrust suit filed in 1991, Sears--which issued the
Discover Card--claimed that VISA members used association bylaws to
prevent efficient low-cost competitors from becoming members and
competing against current VISA members.  In response, VISA argued
that its members had a right to protect their investments in the VISA
logo and computer systems from competitors.  Sears won by jury
verdict in November 1992, but VISA has appealed the decision. 


      CREDIT CARD LENDING DIFFERS
      FROM OTHER CONSUMER LENDING
-------------------------------------------------------- Chapter 0:4.2

Many industry analysts argue that differences between credit card and
other types of lending explain why credit card interest rates were
stable and industry earnings were high during the 1980s.  Most
significantly, credit card lending is riskier than most other lending
activities because it is unsecured, and cardholders use their cards
more when they are in financial distress.  To remain profitable, card
issuers must charge interest rates and generate earnings that
compensate for the risks associated with credit card lending. 
Moreover, operating costs as a percentage of total lending costs are
relatively high for credit card lending, while funding costs are
relatively low.  Because funding costs are relatively low, changes in
funding costs were less influential in shaping credit card interest
rates.  During the 1980s, issuers may have built into credit card
interest rates high "risk-premiums" as they extended credit to
riskier customers. 

Other explanations by economists suggest that the credit card
industry was not under competitive pressures during the 1980s as a
result of cardholder behavior.  Several economists agree that
cardholders have not traditionally shopped around for credit cards
that offer lower interest rates.  This has given credit card issuers
incentives to maintain interest rates and earnings above levels that
would prevail in a more competitive market.  These economists argue
that consumers do not respond to offers for cards with lower interest
rates due to the costs associated with finding a new card and
switching issuers.  Cardholders with high credit card balances and
low incomes may have found it particularly difficult to switch
issuers. 

Recent developments suggest competition is increasing among credit
card issuers.  According to many industry analysts, the slowing of
growth of credit card lending and increased responsiveness by
consumers to interest rates have caused issuers to work harder to
maintain their market shares.  In 1991 and 1992, several major
issuers--such as Citibank--offered credit cards with interest rates
below 16 percent to cardholders with good credit histories. 
Moreover, large nonbank corporations--such as Ford, General Motors,
and General Electric--entered the industry, offered competitively
priced cards, and attracted millions of customers.  As a result, the
number of cardholders with lower interest rate cards increased
substantially.  For example, the percentage of total credit card
accounts subject to annual interest rates of 16.5 percent or less
increased from 9 percent in 1990 to 39 percent in 1992. 

GAO believes that these developments within the credit card industry
should be closely monitored to determine whether the apparent
increase in competitive performance is sustained.  While many
cardholders are clearly benefiting from lower interest rates,
industry earnings remained relatively high throughout 1992 and 1993,
due in part to record low funding costs.  Also, cardholders who
represent higher default risks may not be offered the advantage of
programs designed to lower their borrowing costs.  Therefore, they
may continue to pay interest rates exceeding 18 percent.  Close
monitoring is also warranted because the recent competition among
issuers could lessen if congressional, media, and public scrutiny of
the industry's pricing practices subsides. 

Currently, the Federal Reserve collects and publishes information
about credit card interest rates and other industry issues.  However,
GAO believes the Federal Reserve can provide additional information
about available credit card interest rates.  With such information,
Congress and industry analysts can better monitor the recent price
competition among issuers and assess whether it is sustained in the
short and long term.  Moreover, the Federal Reserve can comment on
recent competitive developments in the industry in its annual report
to Congress on credit card profitability. 


      ANALYSIS OF POLICY OPTIONS
-------------------------------------------------------- Chapter 0:4.3

A nationwide cap on interest rates has been proposed by some credit
card industry critics to remedy a perceived lack of competition in
the industry, protect consumers, and stimulate the economy. 
Economists who oppose a nationwide cap on credit card interest rates
have argued that it would harm rather than stimulate the economy and
compel issuers to cancel the cards of many riskier cardholders. 
Rather than impose a rate cap, they believe that Congress should
maintain a nonintervention policy and permit the credit card market
to determine interest rate levels. 

Another policy option that has been proposed by industry analysts is
strengthening credit card disclosure laws.  Although Congress did
strengthen these requirements when it passed the Fair Credit and
Charge Card Disclosure Act of 1988, additional requirements have been
suggested, such as a requirement that issuers disclose interest rates
and annual fees on the envelopes of cardholder solicitations.  Such
disclosures may benefit some customers, although they may not benefit
those who do not qualify for lower rates and will impose some
additional costs on credit card issuers. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5

GAO recommends that the Federal Reserve (1) collect additional
information on credit card interest rates and (2) comment on recent
competitive developments in the industry in its annual report to
Congress on credit card profitability.  GAO is not recommending that
Congress adopt any particular public policy option. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6

GAO provided copies of a draft of this report to the Attorney General
and the Chairman of the Federal Reserve for their review and comment. 
Although the Attorney General chose not to provide written comments,
the Assistant Chief, Communication and Finance Section of the
Department of Justice Antitrust Division, generally agreed with the
report's analysis and conclusions.  The Assistant Chief and division
officials also suggested some clarifying language on the Department's
activities relative to industry participants, which has been
incorporated in chapter 2. 

The Chairman of the Federal Reserve provided written comments on the
report that are discussed on pages 47-48 and reprinted in appendix
II.  In his written comments, the Chairman said the report is a
comprehensive and well-documented analysis of competitive
developments in the credit card industry.  The Chairman generally
agreed with GAO's recommendations and described additional
information that the Federal Reserve plans to collect on credit card
interest rates that it will report to Congress.  In addition, the
Chairman said the Federal Reserve believes that the credit card
industry is competitive and that, in recent years, issuers have
adopted variable rate pricing strategies that more explicitly track
changes in market interest rates. 


INTRODUCTION
============================================================ Chapter 1

Until 1992, credit card interest rates in the United States had
remained stable at about 18 percent for nearly 20 years despite wide
fluctuations in the amount lenders paid for funds that they loaned to
their customers ("cost of funds").  In addition, since 1983, earnings
in the U.S.  credit card industry have been high compared to earnings
produced by other types of lending.  In 1991, the wide difference
between the cost of funds and average credit card interest rates
reignited congressional concern and a longstanding public debate
about the adequacy of price competition among credit card issuers. 
This report summarizes and assesses various explanations for the
industry's competitive performance; it also discusses the advantages
and disadvantages of various policy options proposed to improve this
performance. 


   BACKGROUND
---------------------------------------------------------- Chapter 1:1

The U.S.  credit card industry began around 1914, when Western Union,
department stores, hotels, and oil companies issued charge cards. 
Typically, customers could use these cards to purchase only the
issuer's product or service, and they were required to pay the amount
charged in full each month.  In 1950, Diners' Club introduced a
"general purpose" charge card, that is, one that was accepted at a
variety of merchant establishments nationwide.  American Express
introduced a similar card in 1958. 

As banks entered the industry as credit card issuers, payment
schedules evolved and nationwide services expanded.  When banks first
entered the credit card business in the 1950s, they issued general
purpose cards that permitted cardholders to make minimum monthly
payments, carrying over balances on which interest was charged. 
However, for more than a decade, the growth of the credit card
industry was slow because most merchants accepted only cards issued
by local banks and no national system existed to process credit card
transactions.  In 1966, the Bank of America began licensing its
BankAmericard credit card logo to other banks, and these
participating banks later formed the entity known today as the VISA
association.  Similarly, another group of banks formed an entity now
known as the MasterCard association in 1966.\1 These associations
each developed efficient, nationwide systems to process credit card
transactions and convinced millions of merchants to accept their
cards.  (Appendix I explains how a typical credit card transaction is
processed.) VISA and MasterCard also established fees for association
membership and transaction processing; however, both allowed members
to set interest rates, annual fees, and any other terms and
conditions for the VISA or MasterCard cards the members issued. 

At first, participating banks could join only one or the other
association, but not both; this changed as a result of antitrust
concerns.  In 1971, a VISA member bank initiated a private antitrust
suit that challenged a VISA bylaw preventing members from joining
MasterCard.  The bank won the case at the district court level, but
an appellate court partially reversed the decision and ordered a new
trial.  Instead of pursuing a new trial, VISA dropped the restriction
in 1975, after learning that the Department of Justice objected on
antitrust grounds to some VISA restrictions against dual
membership.\2 Most of the 6,000 card issuers today issue both VISA
and MasterCard credit cards, a practice referred to as "duality." In
the 1970s, VISA and MasterCard also offered membership to federally
insured thrifts and credit unions. 

In the mid-1980s, the Sears and American Express corporations
established general purpose credit cards, the Discover Card and the
Optima Card, respectively.  The Optima Card (unlike the American
Express charge card) permits customers to carry over balances on
which interest is charged.  Sears and American Express each
established nationwide computer systems to process Discover Card and
Optima Card transactions.  In 1993, Sears divested its Dean Witter,
Discover & Co.  subsidiary, and that corporation now issues the
Discover Card. 


--------------------
\1 VISA was called BankAmericard until 1970 when its name was changed
to National BankAmericard, Inc.  In 1977, the association adopted the
VISA logo.  MasterCard was called the Interbank Card Association
until 1969 and MasterCharge until 1980. 

\2 Worthen Bank & Trust Co.  v.  National BankAmericard Inc., 345 F. 
Supp 1309 (E.D.  Ark.  1972), rev'd, 485 F.2d 119 (8th Cir.  1973),
cert.  denied, 415 U.S.  918 (1974). 


      THE CREDIT CARD INDUSTRY HAS
      GROWN SUBSTANTIALLY SINCE
      THE MID-1980S
-------------------------------------------------------- Chapter 1:1.1

Use of general purpose credit cards has grown substantially in the
United States since the mid-1980s.  VISA and MasterCard members'
total annual charge volume grew by 60 percent in constant 1982
dollars, from about $131 billion in 1986 to about $216 billion in
1992.  Moreover, between yearend 1983 and yearend 1993, total credit
card balances outstanding\3 quadrupled, rising from about $39 billion
to about $156 billion in constant 1982 dollars.  Figure 1.1 shows the
increase in credit card balances outstanding between 1976 and 1993. 
The most rapid growth occurred during the period 1983 through 1990. 
After growing at an average annual rate of 15.5 percent between 1986
and 1990, outstanding balances increased by 5.1 percent in 1991 and
remained flat in 1992 during a period of slow economic growth. 
However, outstanding credit card balances increased by 12.4 percent
in 1993 as the economic recovery strengthened.  According to Federal
Reserve economists, not all of the increased credit card balances
during the 1980s represented long-term borrowing by cardholders. 
Instead, many consumers, who prefer to use credit cards as a
convenient payment mechanism, generally paid off their outstanding
balances at the end of each month.\4

   Figure 1.1:  Total Credit Card
   Balances Outstanding,
   1976-1993, Adjusted for
   Inflation

   (See figure in printed
   edition.)

Constant 1982 dollars in billions

Note:  Based on consumer price index, 1982 to 1984 = 100. 

Source:  The Nilson Company, SMR Research Corporation, and RAM
Research Corporation.  There is no single source of publicly
available historical data about the credit card industry's assets,
revenues, and expenses.  Consequently, we used several different
sources to provide background data for this report.  We used the best
available data to present various aspects of industry performance but
did not attempt to verify these data. 

According to industry analysts, before the early 1980s, most states'
usury laws placed ceilings on interest rates for credit cards held by
consumers.  These laws suppressed the growth of the credit card
industry insofar as issuers in states with low ceilings issued cards
only to the most creditworthy individuals.\5 However, a 1978 Supreme
Court decision, the Marquette case, permitted a card issuer to charge
the interest rate permitted in the institution's home state to its
customers nationwide.\6 Subsequently, many states relaxed their usury
laws and several states--South Dakota, for example--repealed their
usury laws, thus becoming attractive home states for card issuers. 

Higher credit card interest rates enabled issuers to offer cards to
riskier customers who previously may not have qualified.  Charging
higher interest rates compensated the issuers for the risks
associated with offering credit cards to less creditworthy
individuals who were more likely to default on payment of their
credit card debts.  Providing cards to customers who previously did
not qualify also contributed to the surge in demand for credit card
loans during the 1980s.  The long economic expansion of the 1980s
further increased the demand for credit card loans because
cardholders were in a better financial position to make purchases
with their credit cards.  The percentage of American households with
at least one credit card account grew rapidly during the 1980s, from
about 38 percent in 1977 to 54 percent in 1989 (see table 1.1).  Data
also indicate that the percentage of households with at least one
credit card account increased in all income groups. 



                          Table 1.1
           
            Percentage of American Households With
             at Least One Credit Card Account by
                 Household Income, 1977-1989


Household income            1977          1983          1989
------------------  ------------  ------------  ------------
Less than $10,000            11%           10%           16%
$10,000 to 19,999             18            27            37
$20,000 to 29,999             33            42            63
$30,000 to 49,999             49            60            74
$50,000 or more               67            80            87
All households                38            43            54
------------------------------------------------------------
Source:  Federal Reserve Surveys of Consumer Finances, 1977, 1983,
and 1989, conducted in cooperation with other agencies. 

Despite the rapid growth of credit card lending, general purpose
credit card purchases of goods and services in 1990 still accounted
for only about 10.5 percent of the total U.S.  payments system of
$3.5 trillion, according to VISA data.  Cash and checks accounted for
the largest portion, nearly 84 percent, and retailer-issued charge
cards and other payment mechanisms, accounted for the remaining 5.5
percent. 


--------------------
\3 The dollar amount of borrowings owed by cardholders. 

\4 Glenn B.  Canner and Charles A.  Luckett, "Developments in the
Pricing of Credit Card Services," Federal Reserve Bulletin, (Sept. 
1992), pp.  652-666. 

\5 See Canner and Luckett, pp.  652-666 and Christopher C.  DeMuth,
"The Case Against Credit Card Interest Rate Regulation," Yale Journal
of Regulation, Vol.  3:  201 (Winter 1986), pp.  201-242. 

\6 Marquette National Bank v.  First Omaha Service Corporation, 439
U.S.  299 (1978). 


      SOURCES OF CREDIT CARD
      REVENUES AND EXPENSES
-------------------------------------------------------- Chapter 1:1.2

Credit card issuers generate revenues from interest rate charges and
various other fees.  Data collected by the Nilson Company--an
independent firm that follows the industry--indicate that VISA and
MasterCard members generated about $34 billion in revenues in 1991,
including $26 billion (76 percent) from interest charges and $8
billion (24 percent) from cardholders' annual membership fees, fees
charged to merchants for processing credit card transactions, and
other miscellaneous income. 

With regard to expenses, the Nilson data show that total credit card
expenses in 1991 were about $28 billion, including funding costs of
$13 billion (46 percent), charge-offs for bad loans of $8 billion (29
percent), and operating expenses of $7 billion (25 percent).  Funding
costs, also called interest expenses, were incurred as issuers
obtained funds from interest-bearing accounts and the open market. 
Charge-offs reflected balances delinquent for more than 180 days, as
defined and accounted for under federal banking regulations. 
Operating expenses included labor and computer costs incurred to
solicit and maintain cardholders' accounts.  The industry's pretax
income, revenues less expenses, was about $6 billion in 1991. 


   STABLE CREDIT CARD INTEREST
   RATES AND RELATIVELY HIGH
   INDUSTRY EARNINGS HAVE
   GENERATED DEBATE
---------------------------------------------------------- Chapter 1:2

Although in 1992, many credit card issuers began to offer lower
interest rates to creditworthy customers, credit card interest rates
were stable at about 18 percent for nearly 20 years despite wide
fluctuations in the cost of funds.  The stability of these rates,
combined with industry earnings that were high compared to other
consumer lending activities, generated debate about the adequacy of
competition in the U.S.  credit card industry.  While some economists
and industry analysts argued that the industry's relatively high
earnings and stable interest rates indicated a lack of competition,
others disagreed, arguing that other factors, such as risk and
consumer behavior, accounted for the industry's pricing practices and
earnings. 


      DATA AVAILABLE ON CREDIT
      CARD INTEREST RATES ARE
      LIMITED
-------------------------------------------------------- Chapter 1:2.1

The data available on credit card interest rates over the past 2
decades have certain limitations.  The Federal Reserve publishes
quarterly information about the average "most common" annual interest
rates, based on the findings of a survey of a sample of about 160
large banks.  The survey requests banks to provide the interest rate
that applies to the highest dollar amount of outstanding credit card
balances.  The average most common interest rate is the simple mean
of the rates reported; it does not reflect the weighted market share
of each reporting bank.  Also, it does not capture the diversity of
interest rates that a typical issuer may offer its entire customer
base.  For example, some issuers may offer cards with interest rates
lower than their most common interest rate to selected customers who
have good credit histories and who charge a certain dollar volume
each year.  Despite these limitations, we used the average most
common interest rate data when making historical comparisons because
it was the only indicator we had that was based on data collected
consistently over the last 20 years. 

It is important to note that cardholders do not always pay the
interest rate an issuer charges.  The actual interest rate that a
cardholder pays depends upon the extent to which he or she takes
advantage of grace periods--the time period issuers allow cardholders
to carry their charges without interest charges.  Cardholders who
always repay their charges in full within the typical grace period of
25 to 30 days pay actual interest rates of zero.  On the other hand,
cardholders who regularly carry balances pay effective rates closer
to the interest rate stated by the issuer.  Consumer surveys estimate
that about one-third of all cardholders consistently take advantage
of grace periods, while the remaining two-thirds occasionally or
always pay interest.\7


--------------------
\7 Although about 50 percent of consumers report that they pay their
balances in full each month, surveys of actual repayment patterns
indicate that only about one-third do so. 


      AVERAGE INTEREST RATES WERE
      STABLE FOR MANY YEARS
-------------------------------------------------------- Chapter 1:2.2

Figure 1.2 shows that the average most common interest rate has
remained stable at about 18 percent for many years, ranging from
16.89 percent in 1977 to 18.78 percent in 1983.  However, in recent
years, the average rate has declined from 18.23 percent in 1991 to
17.76 percent in 1992, and it further declined to 16.83 percent in
1993.  During the period that the average most common interest rate
was generally stable, the cost of funds fluctuated significantly. 

   Figure 1.2:  The Average Most
   Common Interest Rates and
   Funding Costs for Credit Card
   Issuers, 1976-1993

   (See figure in printed
   edition.)

Note:  Credit card funding costs are a percentage of average
outstanding balances. 

Source:  Federal Reserve data and VISA. 

As shown in figure 1.2, credit card funding costs as a percentage of
average outstanding balances jumped from 5.83 percent in 1976 to
13.38 percent in 1981.\8 The funding costs fell substantially in 1992
to 6.34 percent and then dropped further to 5.33 percent in the first
9 months of 1993.  The difference between the credit card interest
rate and the cost of funds reached 11.50 percentage points in 1993,
the highest level since 1976.\9

The average most common credit card interest rate has also remained
stable over the past decade compared to interest rates on other types
of consumer loans, as shown in figure 1.3.  For example, while the
average interest rate on personal loans fell from 18.65 percent in
1982 to 13.47 percent in 1993, the average most common credit card
interest rate remained generally stable at between 17 and 18 percent. 
While average personal loan rates have fluctuated more widely than
average credit card interest rates over time, credit card interest
rates did decline more rapidly between 1992 and 1993.  Specifically,
credit card interest rates fell from 17.76 percent in 1992 to 16.83
percent in 1993 (a decline of .93 points or 5.2 percent), while
personal loan rates fell from 14.04 percent to 13.47 percent (a
decline of .57 points or 4.1 percent).  The most common credit card
interest rate began to decline more rapidly than some other types of
interest rates in 1992 and 1993 as a result of increasing price
competition among card issuers. 

   Figure 1.3:  Average Credit
   Card, Personal, and New Car
   Loan Interest Rates, 1976-1993

   (See figure in printed
   edition.)

Source:  Federal Reserve data. 


--------------------
\8 The data represent credit card issuers' expenditures on funding
costs as a percentage of their average annual outstanding balances. 
These data, which were provided by VISA, represent the funding costs
for VISA and MasterCard issuers. 

\9 Average credit card interest rate data are for all of 1993, while
the funding cost data are for the first 9 months of the year. 


      MANY CARDHOLDERS WERE
      OFFERED LOWER INTEREST RATES
      IN 1992
-------------------------------------------------------- Chapter 1:2.3

In late 1991 and throughout 1992, several large card issuers began to
offer lower interest rate cards to cardholders with good credit
histories and annual total credit card charges of at least $1,000. 
Many issuers also began offering variable-rate cards indexed to the
prime lending rate.  (This means that if the cost of funds rises or
falls, the credit card interest rate rises or falls proportionately.)
In addition, during 1992 and 1993, several nonbanks, such as General
Motors, Ford, and General Electric, entered the credit card business
and began to offer relatively low variable rate interest rates and
other incentives to attract potential customers.  The nonbanks have
established several different approaches to gain entry into VISA and
MasterCard and to issue their credit cards.  For example, some
nonbanks, such as General Electric, have acquired federally insured
depository institutions and thereby gained association membership.\10
Other nonbanks, such as AT&T--which introduced its Universal Card in
1990--and General Motors, have established contractual relationships
with existing VISA and MasterCard members to issue credit cards in
the nonbanks' names and to process associated credit card
transactions.\11

Because of these new offerings, the number of cardholders who
qualified for lower interest rates increased substantially in 1992. 
The RAM Research Corporation, an independent firm that tracks credit
card rates, found that the percentage of total credit card accounts
subject to annual interest rates of 16.5 percent or less, increased
from 9 percent in 1990 to 39 percent in 1992.  Meanwhile, the
percentage of total credit card accounts subject to annual interest
rates of 18 percent or more, fell from 69 percent in 1990 to 43
percent in 1992.  In chapter 3, we discuss possible reasons for these
new offerings and some of their implications. 

Credit card interest rates are important because they account for
most credit card revenues; however, card issuers may compete on other
terms and features of credit card accounts.  As examples, issuers
have competed on credit card enhancements, such as frequent flyer
miles, rebates, annual fees, and credit limits.  When Sears
introduced its Discover Card in 1986, it offered cardholders rebates
of up to 1 percent of their total annual credit card purchases. 
Also, new industry nonbank entrants offered rebates on amounts
charged and credits for future purchases.  Such enhancements are
designed to make these and other nonbank companies more competitive
in the credit card industry, as well as in their primary lines of
business.  After AT&T entered the credit card business in 1990 and
offered a "no annual fee for life" incentive on its Universal credit
card, several other issuers, including the major issuers, waived
annual fees or offered cards without annual fees.  In addition,
issuers have competed on cardholder credit limits, with higher credit
limits being extended to lower-risk cardholders. 


--------------------
\10 General Electric offers MasterCard credit cards through its
Monogram Bank subsidiary. 

\11 AT&T has established a contractual relationship with Synovous
Bank of Georgia while General Motors has established a contractual
relationship with Household International, Inc. 


      CREDIT CARD EARNINGS HAVE
      BEEN RELATIVELY HIGH IN
      RECENT YEARS
-------------------------------------------------------- Chapter 1:2.4

Figure 1.4 shows the average pretax earnings as a percentage of
average outstanding balances (the usual measure of earnings for
credit card issuers) for VISA and MasterCard issuers between 1976 and
1993.  A percentage of earnings to outstanding balances measure is
comparable to a return on assets, a standard measure of profitability
for other businesses.  In the late 1970s and early 1980s, card
issuers experienced low earnings or even losses because of the many
state usury laws' caps on credit card interest rates.  These interest
rate caps prevented issuers from recovering their total costs of
operations, which had increased because of a sharp rise in the cost
of funds. 

Figure 1.4 also indicates that the pretax earnings of credit card
issuers began to recover in 1982, increased substantially in 1983,
began to decline gradually afterwards, and started to recover in 1992
and 1993.  Between 1983 and 1990, VISA and MasterCard issuers'
earnings averaged 4.68 percent of outstanding balances, while the
overall earnings of banks in general averaged .57 percent of assets
(bank assets consist primarily of loans including credit card loans). 
In 1991, VISA and MasterCard issuers' average earnings fell to 3.55
percent, partly as a result of higher charge-off costs following the
recession.  However, average earnings reached 4.02 percent in 1992
and 4.53 percent in the first 9 months of 1993, partly because of a
substantial decrease in funding costs. 

   Figure 1.4:  Average Pretax
   Earnings of VISA and MasterCard
   Issuers, 1976-1993

   (See figure in printed
   edition.)

Note:  These earnings data, which were provided by VISA, represent
the overall profitability for credit card lending at depository
institutions.  The data do not distinguish between the earnings
generated on VISA and MasterCard balances because most issuers offer
both types of cards.  The combined market share of VISA and
MasterCard members is about 90 percent of outstanding balances.  Data
for 1993 are for the first 9 months of the year. 

Source:  VISA. 

VISA and MasterCard members had relatively high earnings in recent
years despite relatively high charge-off costs for bad loans.  Figure
1.5 shows that the average charge-off rate for VISA and MasterCard
members' credit card lending has consistently exceeded the charge-off
rate for commercial bank lending as a whole.  Between 1990 and 1992,
the charge-off rate, as a percent of outstanding credit card
balances, increased from 3.88 percent to 5.17 percent.  Although the
credit card charge-off rate fell to 4.37 percent in the first 9
months of 1993, it was still more than five times the charge-off rate
for commercial bank lending.\12

   Figure 1.5:  Charge-off Rates
   for Credit Card Lending and
   Commercial Bank Lending
   Activities, 1981-1993

   (See figure in printed
   edition.)

Note:  The credit card charge-off data, which were provided by VISA,
represent the overall charge-off rate for credit card lending at
depository institutions.  The data do not distinguish between the
charge-off rates incurred on VISA and MasterCard balances since most
issuers offer both types of cards.  Data for 1993 are for the first 9
months of the year. 

Source:  VISA and FDIC. 


--------------------
\12 For more information about the differences in profitability
between credit card and other types of lending, see Lawrence M. 
Ausubel, "The Failure of Competition in the Credit Card Market,"
American Economic Review, Vol.  81, No.  1 (Mar.  1991), pp.  50-81;
Paul S.  Calem, "The Strange Behavior of the Credit Card Market,"
Business Review, Federal Reserve Bank of Philadelphia, (Jan./Feb. 
1992), pp.  3-13; S.  Park, The Credit Card Industry:  Profitability
and Efficiency, Federal Reserve Bank of New York (July 1992); and
Paul R.  Watro, "The Bank Credit-Card Boom:  Some Explanations and
Consequences," Economic Commentary, Federal Reserve Bank of Cleveland
(Mar.  1, 1988). 


      CREDIT CARD INTEREST AND
      EARNING RATES HAVE ATTRACTED
      CONGRESSIONAL ATTENTION
-------------------------------------------------------- Chapter 1:2.5

In 1985 and 1986, the former House Subcommittee on Consumer Affairs
and Coinage, Committee on Banking, Finance and Urban Affairs and the
former Senate Subcommittee on Financial Institutions and Consumer
Affairs, Committee on Banking, Housing, and Urban Affairs held
hearings on the reasons average credit card interest rates did not
fall despite substantial decreases in funding costs since the early
1980s.  At the hearings, some industry critics, arguing that the
stability of average interest rates indicated inadequate price
competition among credit card issuers, suggested that the government
impose interest rate caps on credit cards.  Other witnesses,
including Federal Reserve officials, contended that the U.S.  credit
card industry was structurally competitive and that risks associated
with credit card lending explained why high interest rates did not
fall.  These officials argued that imposing interest rate caps would
disrupt the market and force issuers to cancel the cards of many
riskier customers. 

Congressional attention again focused on competition within the U.S. 
credit card industry during the fall of 1991.  In November, President
Bush publicly remarked that credit card rates were too high and that
lower rates could help the economy recover from its prolonged
recession.  Senator Alfonse D'Amato then introduced a measure that
would have limited credit card rates to 14 percent.  Although the
Senate passed this measure overwhelmingly by a vote of 74 to 19, the
legislative session ended before the House acted on such a rate cap. 
The proposal raised considerable controversy, with industry
representatives arguing that the proposed limits would result in
widespread card cancellations and credit line curtailments for many
customers.  Some industry analysts also believe the legislation
disrupted trading in the markets for securities backed by outstanding
credit card balances. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:3

We received two separate requests to assess the competitive
performance of the U.S.  credit card industry.  The first request
came jointly from former Chairman Esteban E.  Torres, House
Subcommittee on Consumer Affairs and Coinage, House Committee on
Banking, Finance and Urban Affairs, and Congressman Charles E. 
Schumer.  The second request came from the Subcommittee's Ranking
Minority Member, Al McCandless, and the former House Banking
Committee Ranking Minority Member, Chalmers P.  Wylie.  On the basis
of discussions with the requesters, our objectives were to review the
(1) assessments of whether the credit card industry's structure
supports competition, (2) explanations that have been offered for the
credit card industry's relatively stable interest rates and high
earnings, and (3) proposed credit card interest rate cap and various
other policy options. 

To meet these objectives, we analyzed available credit card industry
data to identify trends and patterns in costing, pricing, and
earnings.  Because there is no single data source for credit card
performance over time, we used the best available data relevant to
the issues raised by various industry analysts and critics.  We also
reviewed the related economic literature and several industry
studies.  Except where noted, we did not try to independently verify
or replicate the methodologies of these studies.\13 We also obtained
and reviewed court documents of recent antitrust litigation between
Sears and VISA involving, among other issues, alleged barriers to
entry into the U.S.  credit card industry.  We reviewed these
documents, to better understand the issues raised in the litigation,
as well as the structural characteristics of the credit card industry
that allegedly limit competition. 

We also interviewed economists, financial analysts, industry
executives, and consumer advocates to obtain their views on
competition in the credit card industry and to identify the
advantages and disadvantages of various policy options.  We met with
officials from VISA and MasterCard, Sears, American Express, RAM
Research Corporation, the Nilson Company, and Bankcard Holders of
America, among others.  We contacted representatives from each of the
federal bank and thrift regulatory agencies:  the Federal Reserve,
the Office of the Comptroller of the Currency, the Federal Deposit
Insurance Corporation, and the Office of Thrift Supervision. 
Additionally, we contacted officials at the Department of Justice who
are responsible for investigating allegations of anticompetitive
industry practices and officials from the Federal Trade Commission. 

We provided copies of a draft of this report to the Attorney General
and the Chairman of the Federal Reserve for their review and comment. 
Although the Attorney General chose not to provide written comments,
the Assistant Chief, Communications and Finance Section of the
Department of Justice Antitrust Division, commented on the report's
findings and analysis.  He and division officials also provided
technical comments that have been incorporated in chapter 2.  The
Chairman of the Federal Reserve provided written comments on the
draft report's analysis and recommendations that are provided in
appendix II. 

We did our work between May 1992 and October 1993 in New York City,
San Francisco, and Washington, D.C., in accordance with generally
accepted government auditing standards. 


--------------------
\13 A list of these studies is provided at the end of the report. 


WIDELY HELD VIEW THAT THE CREDIT
CARD INDUSTRY'S STRUCTURE IS
COMPETITIVE FACES SOME CHALLENGES
============================================================ Chapter 2

The stability of average credit card interest rates and the
industry's relatively high earnings have perplexed many analysts and
generated much controversy.  Because stable prices and high earnings
are often viewed as indicators of anticompetitive conditions,
government and private sector economists have analyzed the credit
card industry's structure to determine the extent to which it might
have facilitated anticompetitive practices.  These analyses have
generally concluded that the industry's structure provides for
adequate competition among credit card issuers. 

On the other hand, an alternative viewpoint suggests that certain
characteristics of the credit card industry's structure may have
limited competition.  One argument is that the largest card issuers,
who collectively hold a significant portion of the industry's
outstanding balances, have conformed to one another's pricing
decisions over the years.  Another argument is made by Sears, that
alleged in an ongoing private antitrust suit that large bank issuers
use VISA's membership rules to limit the competition from firms that
have established independent credit cards, such as the Discover
credit card.  This antitrust controversy has not yet been resolved in
the courts. 


   THE STRUCTURAL CHARACTERISTICS
   OF THE CREDIT CARD INDUSTRY AT
   THE CARD ISSUER LEVEL
---------------------------------------------------------- Chapter 2:1

At the card issuer level, the credit card industry displays many of
the structural characteristics of a competitive industry.  It has a
large number of participants, modest concentration levels, and
relatively low barriers to entry for new card issuers.  In addition,
the Department of Justice, which has monitored the credit card
industry over the years, has not instituted proceedings against any
firm charging an antitrust violation in its credit card operations. 
It is true, however, that certain large issuers had the same most
common annual interest rate of 19.8 percent for several years.  This
may have occurred because these issuers hold about half of all
outstanding credit card balances and followed one another's pricing
decisions.  However, other analysts do not believe that there is
sufficient evidence to conclude that issuers have engaged in this
practice. 


      STANDARD MEASURES SUGGEST
      THAT THE INDUSTRY IS
      COMPETITIVE AT THE CARD
      ISSUER LEVEL
-------------------------------------------------------- Chapter 2:1.1

Although the credit card industry is composed of both card issuers
and card associations--VISA and MasterCard--most analysts generally
view card issuers as the relevant level of business for assessing the
industry's competitiveness.  This view is based on the fact that
individual issuers own cardholders' accounts, set credit card
interest rates and other terms, and make other business decisions. 
Many analysts have found that the structure of the credit card
industry at the issuer level has those characteristics that favor
competition.  These characteristics are discussed next. 

  a large number of competitors

Nearly 6,000 depository institutions issue credit cards--a much
larger number of competitors than exist in many other industries. 

  a lack of concentration

The Department of Justice and the Federal Trade Commission use the
Herfindahl-Hirschman Index (HHI) to measure market concentration.\1
Industries with HHI values below 1,000 are considered unconcentrated,
and those with HHI values above 1,800, highly concentrated.  Although
estimates vary, most analysts place the HHI value for the credit card
industry at less than 564.\2

  few barriers to entry for depository institutions that wish to
     issue credit cards

VISA and MasterCard permit virtually any federally insured depository
institution (bank, thrift, or credit union) to join and issue their
credit cards.  Approximately 4,500 of the 6,000 depository
institutions that issue credit cards joined VISA and/or MasterCard
between 1980 and 1991.  Approximately 14,000 "participating"
institutions offer credit cards under their names, but conform to
pricing decisions made by issuing institutions with whom they have
established contractual relationships.\3 For example, the
participating institutions charge credit card interest rates
specified by the card issuers. 

The number of competitors and the relatively modest concentration
levels in the industry are regarded by many analysts as compelling
evidence that the industry structure does not favor anticompetitive
practices by credit card issuers.  To date, the Department of Justice
has not instituted any antitrust proceedings against any firm
charging an antitrust violation in its credit card operations. 
However, Department of Justice officials told us that they continue
to monitor the industry, as they routinely monitor other significant
industries, to detect potential antitrust violations. 


--------------------
\1 The HHI value represents the sum of the squared percentage shares
of every firm in the market chosen to do the analysis (i.e., the
relevant market).  Thus, a relevant market with ten firms each with
10 percent market share, has an HHI value of 1,000. 

\2 The HHI value estimates vary depending upon the definition of the
relevant market and the year chosen to do the analysis.  Robert
Litan, in his 1992 study, Consumers, Competition, and Choice:  The
Impact of Price Controls on the Credit Card Industry, estimated that
the HHI value for the credit card industry was 375 in 1990.  Mr. 
Litan's definition of the relevant market included traditional VISA
and MasterCard issuers, as well as store and oil company charge
cards.  Using a sample of 124 VISA issuers, Richard Schmalansee, an
expert witness for VISA, estimated the industry's HHI value at 453 in
1990.  On the basis of data provided by the RAM Research Corporation
for yearend 1992, we estimated the HHI value for the industry was
about 564.  The data consisted of the 212 largest general purpose
credit card issuers who accounted for about 95 percent of industry
balances.  This estimate of the industry's HHI value would have been
lower if all 6,000 issuers had been included in the calculation. 

\3 Although regulatory barriers to entry in the credit card industry
are generally considered low, in 1991, Sears initiated an antitrust
suit against VISA alleging it has been prevented from joining the
association.  This issue is discussed later in this chapter. 


      THERE IS A POTENTIAL FOR
      "TACIT COORDINATION" AMONG
      LARGE CREDIT CARD ISSUERS,
      BUT THE EVIDENCE IS
      INCONCLUSIVE
-------------------------------------------------------- Chapter 2:1.2

We were asked to assess the extent of competition among the 10
largest credit card issuers and to assess why several of these
issuers had charged the same most common interest rate of 19.8
percent for several years, despite substantial declines in the cost
of funds.  Although standard measures of the industry's structure
suggest that it should be competitive, some analysts and
congressional critics have suggested that large issuers may dominate
the industry and thereby limit interest rate competition.  An
industry dominated by several large firms is called an oligopoly. 

Although there is no single explanation for how prices charged to
consumers are determined in an oligopoly, it is clear that the
pricing decisions by any one firm are significantly influenced by the
pricing decisions of its rivals.  Economists have shown that if the
firms in an oligopoly form a cartel, they can maximize their earnings
by formally negotiating price and output decisions at least over the
short term.  However, such price fixing among firms is illegal under
U.S.  antitrust laws.  In certain circumstances, however, firms could
achieve the same ends through "tacit coordination," i.e.,
establishing, without an explicit agreement, a market price that
resembles a formally negotiated price. 

One form of tacit coordination is a situation in which a clearly
dominant firm acts as a price leader.  That is, the price leader sets
a price and the other firms in the industry follow by setting the
same price.  Another form of tacit coordination exists when a firm
matches a price cut by its rivals because to do otherwise would
result in a loss of its customers.  However, the firm would not
necessarily match price increases because it could attract customers
from its rivals who had raised their prices.  Economists believe that
this form of tacit coordination results in stable prices that are
unlikely to change in response to small- or medium-sized changes in
firms' cost of producing the good or service.\4 Either form of tacit
coordination is easiest to achieve when (1) the market is limited to
a few firms; (2) the market is characterized by a stable demand for
the good or service, rather than by wide fluctuations in demand; and
(3) the good or service being offered by each firm is generally the
same. 

It could be argued that the structural characteristics of the credit
card industry are favorable toward tacit coordination among card
issuers.  First, although there are about 6,000 card issuers and the
industry has modest concentration levels, as measured by the HHI
value, the 10 largest credit card issuers hold about 57 percent of
outstanding balances (see table 2.1).  In a 1992 paper, an economist
suggested that, because of their collective market share of about 50
percent, the largest card issuers may have engaged in price
leadership.\5 Second, despite the surge in credit card borrowing
during the 1980s, the market has not been characterized by wide
fluctuations in demand (i.e., periods of high demand followed by
sharp reductions in demand).  Third, each issuer generally offers a
similar product to its customers, a convenient means of payment and
borrowing. 



                          Table 2.1
           
            Outstanding Balances of the 10 Largest
            Credit Card Issuers, December 31, 1992

                       Total outstanding
                       balances (dollars        Market share
Card issuer                 in billions)             percent
--------------------  ------------------  ------------------
Citicorp                           $35.5               18.3%
Sears' Discover                     16.4                 8.4
Chase Manhattan                      9.8                 5.0
MBNA America                         9.2                 4.8
First Chicago                        8.5                 4.4
Bank of America                      8.1                 4.2
AT&T Universal                       6.6                 3.4
Chemical Bank                        5.8                 3.0
Household Bank                       5.7                 2.9
Bank of New York                     4.9                 2.5
============================================================
Totals                            $110.5               56.9%
------------------------------------------------------------
Source:  RAM Research Corporation. 

Based on our discussions with industry analysts and review of studies
on the credit card industry's competitive performance, the available
evidence does not appear to suggest that any one credit card issuer
has acted as a dominant price leader.\6 However, several of these
large card issuers charged the same most common interest rate of 19.8
percent over a period of several years.  This suggests that these
large card issuers may have engaged in the second form of tacit
coordination, whereby firms will not necessarily match a price
increase made by their rivals but will match a price decrease, that
generally results in stable pricing. 

Although several large card issuers charged the same most common
interest rate of 19.8 percent over a period of several years, there
is some evidence that these issuers have not behaved according to the
tacit coordination model discussed above.  Specifically, some large
card issuers have lowered their interest rates in the past, but their
rivals have not matched these interest rate decreases.  For example,
in 1986, the former Manufacturer's Hanover Bank reduced its credit
card interest rates from 19.8 to 17.8 percent and, in 1988, Chase
Manhattan Bank reduced its credit card interest rates from 19.8 to
17.5 percent.  Other large issuers, such as Citibank, did not match
these interest rate decreases, and, by 1990, Manufacturer's Hanover
and Chase Manhattan had resumed charging the most common annual
interest rate of 19.8 percent on their credit cards.\7

Moreover, some analysts are not convinced that the largest card
issuers control a sufficient percentage of outstanding credit card
balances for tacit coordination to exist.\8 A Federal Reserve
economist we contacted also said that the fact that several large
issuers have charged the same most common annual interest rate is
consistent with theories about open competition.  If these large
issuers offer their cards to similar customer groups and have similar
expenses, economists would expect these issuers to charge similar
interest rates in a competitive market.\9 We have noted that several
of these large issuers also charge the same prime lending rate to
their large corporate customers. 

The limitations of available data and the unique aspects of the
credit card business discussed in chapter 1 also complicate any
analysis of pricing trends in the credit card industry.  The focus on
the most common interest rates overlooks the interest rates charged
to groups other than those with the highest credit balances. 
Moreover, as discussed in chapter 1, large issuers compete on terms
other than the credit card interest rate, such as annual fee levels,
rebates, and various enhancements. 


--------------------
\4 Edwin G.  Dolan and David E.  Lindsey, Economics, (The Dryden
Press, 1991), p.  683.  This latter form of tacit coordination is
referred to as the "kinked demand curve" theory of oligopoly. 

\5 Carl Shapiro, Controlling Credit Card Costs, Haas School of
Business, University of California, Berkeley, (Dec.  1992).  This
study was sponsored by American Express. 

\6 For example, according to one economist, the largest firm must
control 50 to 95 percent of the relevant market to be a dominant
price leader.  Douglas F.  Greer, Industrial Organization and Public
Policy, 3rd Ed.  (New York:  Macmillan Publishing Company, 1992), p. 
372. 

\7 The fact that large card issuers did not match the interest rate
cuts by Manufacturer's Hanover and Chase Manhattan, and the fact that
these banks raised their rates to 19.8 percent later in the decade
suggests that consumers may have been indifferent to credit card
interest rates during the 1980s.  This issue is discussed further in
chapter 3. 

\8 Lexecon, Inc., Economic Analysis of VISA's Exclusion of Sears,
(Chicago, June 5, 1992), p.  20.  This study was sponsored by Sears. 
The authors do note that tacit coordination may be possible if the
largest issuers have significant cost advantages over the smaller
issuers.  However, they have not studied whether the larger issuers
have such cost advantages. 

\9 Large issuers tend to offer their cards to riskier customers,
including younger customers with shorter credit histories, and charge
higher rates to compensate for these risks than do smaller issuers. 


   VISA AND MASTERCARD HAVE BEEN
   THE SUBJECTS OF ANTITRUST
   LAWSUITS
---------------------------------------------------------- Chapter 2:2

The VISA and MasterCard associations are organized as joint ventures
among credit card issuers who otherwise compete against one another
for cardholder business.  The associations have various
responsibilities, including (1) developing and maintaining automated
transaction processing systems, also known as authorization and
settlement systems; (2) setting fees for use of the automated
systems; (3) establishing rules and membership bylaws; and (4)
initiating advertising campaigns to increase credit card usage. 
Under VISA and MasterCard rules, a member card issuer that belongs to
both associations may have a representative on the board of directors
of one association and may have representatives on the policymaking
committees of the other association.  However, the member institution
may not have representatives on the boards of directors of both
associations. 

Because of their structure and dual membership, VISA and MasterCard
have been the subjects of various antitrust lawsuits, which, for the
most part, they have fought successfully.  For example, in 1986, VISA
successfully defended its members' right to collectively set fixed
fees that banks pay one another during credit card transactions.\10
The plaintiff in the case, Nabanco, was an independent company that
wanted to process credit card transactions for card issuers and
merchants.  Nabanco argued that the fixed fees established
collectively by VISA members were designed to prevent independent
companies from entering the credit card processing business.  VISA
won the case at both the federal district and appellate court levels. 
In its decision, the appeals court concluded that VISA members should
be granted latitude to set fixed fees to ensure the efficient
operations of the VISA system. 


--------------------
\10 See National Bancard Corporation v.  VISA, 779 F.2d 592 (11th
Cir.), cert.  denied, 479 U.S.  923 (1986). 


      PENDING LITIGATION INVOLVES
      VISA MEMBERSHIP RULES
-------------------------------------------------------- Chapter 2:2.1

In an ongoing lawsuit filed in 1991, Sears, which issued the Discover
Card, challenged a VISA membership bylaw that expressly named Sears
and American Express as ineligible for membership.  Sears had
unsuccessfully tried to join VISA by purchasing from the Resolution
Trust Corporation a failed savings and loan in Utah, MountainWest
Savings and Loan, that was already a VISA member.  MasterCard had
also denied a similar application for membership from Sears and was
involved in separate litigation with Sears in a New York federal
district court.  This litigation was settled in November 1993 and is
discussed later in this section.  Although acknowledging that VISA
members compete against one another, Sears argued that card issuers
acted anticompetitively by using the association's membership bylaws
to prevent low-cost competitors from joining VISA.  Sears also argued
that VISA members acted as a group, rather than as individual
competitors, to protect their high earnings from unwanted
competition.  Furthermore, Sears called the association's rulemaking
authority a potential anticompetitive force because VISA's and
MasterCard's members have a 72-percent collective market share of
annual credit card charge volume. 

During the trial, further evidence was presented that VISA and its
members took steps to limit competition from the Discover Card.  For
example, during the mid-1980s, VISA tried to prevent merchants who
accepted VISA credit cards from processing Discover Card transactions
on the merchants' computer terminals.  Sears also alleged that some
VISA members tried to block AT&T's entry into the credit card
industry by attempting to initiate regulatory action against AT&T in
its efforts to introduce the Universal credit card in 1990.  As
pointed out in chapter 1, AT&T was able to issue a VISA credit card
by establishing a card-processing relationship with another VISA
member, Synovous Bank of Georgia. 

At the trial, VISA denied that its membership restriction policy
against Sears and American Express was anticompetitive, arguing that
the restriction was justified on several grounds.  For example, VISA
claimed that the policy's intention was to protect its members'
investments and property rights from "direct competitors"--Discover
and Optima--who had established their own credit cards.  VISA
defended that intention by saying that economists and courts
traditionally recognized the right of firms to protect their
investments and property--such as VISA members' investments in the
association's logo and computerized transaction settlement
systems--because that right created incentives to develop superior
products that benefited consumers. 

VISA also asserted that permitting Sears to join it would further
diminish "intersystem" competition in the credit card industry. 
Intersystem competition is typically defined as the competition among
VISA, MasterCard, Sears, and American Express.  As examples, these
entities compete to promote consumer use of their cards and to
develop lower-cost card processing technologies.  Intersystem
competition had already been diminished, VISA argued, by VISA and
MasterCard's sharing of a common pool of members.  According to VISA
officials, granting Sears VISA membership would further weaken
intersystem competition in that Sears could cancel its Discover Card
once it was admitted as a member. 

In November 1992, Sears won the initial round of this antitrust
dispute when the jury at the Federal District Court in Salt Lake City
ruled in Sears' favor.  On April 2, 1993, the trial judge issued an
opinion that upheld the jury decision.  However, in his decision, the
judge prevented Sears from issuing a VISA card until VISA had an
opportunity to appeal the decision to a higher court.  After
acknowledging that Sears had presented sufficient evidence for the
jury to conclude that VISA's membership policy was anticompetitive,
the judge stated his belief that requiring VISA to grant membership
to Sears would not necessarily provide long-term material benefits to
consumers.  He noted that Sears charged (at the time of the trial) an
interest rate of 19.8 percent on its Discover Card and an interest
rate exceeding 20 percent on its store charge cards.\11 However, he
agreed with VISA that permitting Sears to join VISA would further
diminish intersystem competition in the credit card industry.  VISA
filed for an appeal to the court's decision on May 6, 1993. 

Since the court's decision, Sears completed a previously announced
divestiture of its Dean Witter, Discover & Company financial services
subsidiary.  Dean Witter now issues the Discover Card and, as the
owner of MountainWest Savings and Loan in Utah, is involved in the
litigation against VISA.  VISA officials said they will continue to
pursue their appeal even though MasterCard has since settled its
litigation with Dean Witter. 

In November 1993, MasterCard settled its ongoing litigation with Dean
Witter that had involved Sears prior to the divestiture.  In the
settlement, MasterCard authorized Dean Witter to issue a MasterCard
credit card by establishing a contractual relationship with an
existing association member, NationsBank of Charlotte, N.C. 
NationsBank will issue the credit card, called Prime Option
MasterCard, but will share revenue and expenses with Dean Witter. 


--------------------
\11 Sears subsequently introduced a program that offers lower
interest rates to Discover cardholders who charge at least $500
annually and are not late on consecutive payments. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 2:3

The structure of the credit card industry meets the standard criteria
for competitiveness in terms of its number of card issuers and lack
of concentration.  Although it is possible that large issuers have
influenced interest rate levels through tacit coordination, no
compelling evidence exists to either confirm or reject this
explanation for the stability of average most common interest rates
and the industry's relatively high earnings compared to earnings on
other bank assets.  The ongoing VISA-Dean Witter litigation is likely
to be important regarding the impact of certain membership
restrictions on the competitiveness of the U.S.  credit card
industry. 


CREDIT CARD LENDING DIFFERS FROM
OTHER TYPES OF CONSUMER LENDING
============================================================ Chapter 3

Many analysts argue that differences between credit card and other
types of consumer lending help explain why credit card interest rates
were stable and industry earnings were relatively high during the
1980s.  Some of these analysts agree that the higher risk of credit
card lending accounts, at least in part, for the performance of
credit card interest rates and earnings.  Other factors cited include
the unique cost structure of credit card lending, the effects of the
expanding economy on competition within a relatively young industry
and consumer behavior, such as consumers' indifference to credit
cards with lower annual interest rates.  For various reasons,
competition in pricing among issuers is increasing and many
cardholders, especially those who are better credit risks, are being
charged lower interest rates.  However, we believe that these
developments need to be closely monitored to assess their long-term
effects on industry competition. 


   RISKS AND COSTS OF CREDIT CARD
   LENDING AND THE LONG ECONOMIC
   EXPANSION OF THE 1980S
---------------------------------------------------------- Chapter 3:1

To explain the historical performance of credit card interest rates
and earnings, industry analysts have cited its high risks and unique
costs, such as high charge-off and operating costs.  Analysts have
also pointed out that during the economic expansion of the 1980s,
card issuers (1) charged relatively high interest rates to compensate
for customers who represented higher default risks and had obtained
credit cards for the first time and (2) had few incentives to lower
their interest rates because the growth in credit card lending
ensured sufficient business for all competitors.  Furthermore, these
analysts say that as growth slows and the credit card industry
matures in the 1990s, card issuers should have greater incentives to
compete on interest rates and other pricing terms. 


      LENDING RISKS HELP EXPLAIN
      CREDIT CARD INTEREST RATES
      AND EARNINGS
-------------------------------------------------------- Chapter 3:1.1

Some industry analysts believe that the stable interest rates and the
relatively high earnings of the credit card industry in the 1980s can
be explained primarily by the high credit risk of credit card
lending.  As mentioned in chapter 1, the average annual charge-off
rates for VISA and MasterCard members from 1981-1993 consistently
exceeded the average charge-off rates for commercial bank lending in
the same period.  In 1993, the charge-off rate for credit card
lending was more than five times the charge-off rate for all bank
lending.  Most other types of consumer lending--such as loans for new
cars--are collateralized and involve the extension of a fixed amount
of credit under fixed terms of repayment (i.e., the borrower must
repay an established amount of principal plus interest each month). 
Credit card loans present greater risks in that they are unsecured,
available to large and heterogenous populations, and can be repaid on
flexible terms at the cardholders' convenience.  Moreover,
cardholders tend to borrow more on their credit cards when they are
financially stressed, and credit cards are highly subject to
fraudulent use. 

An argument has also been made that some cardholders, who are
attracted by low interest rate credit cards, pose higher default
risks to issuers.  If so, issuers who lower their credit card
interest rates may disproportionately attract these types of
potential customers.  Therefore, issuers have incentives to maintain
interest rates at relatively high levels.\1

This phenomenon may partly explain the recent losses that American
Express incurred on its Optima credit card.  American Express first
offered the card in 1987 to its established charge card customers. 
The Optima Card's 13.5 percent interest rate was relatively low
compared to the 18-percent rate that was then the industry's average
most common interest rate.  In industry reports, analysts said that
most American Express charge card customers already had three or four
credit cards and did not respond to offers for the new Optima credit
card.  However, those customers who responded to the offers for the
Optima Card--and its annual interest rate of 13.5 percent--reportedly
presented higher-than-expected default rates.  Many of these
cardholders defaulted on their Optima debts, and by 1992, American
Express had lost more than $1 billion on the card.  In 1992, Optima's
charge-off rate of approximately 10 percent of outstanding balances
was about twice the industry average. 

However, some economists have questioned whether the risks that exist
fully explain the sustained high credit card interest rates and
earnings of the 1980s.  Credit card earnings have been substantial
despite high charge-offs of unpaid balances.  As discussed in chapter
1, issuers' earnings on credit card balances have generally averaged
more than 4 percent of the average outstanding balances since 1983,
despite charge-off rates as high as 5 percent.  By contrast, the
average earnings of banks as a percentage of assets has been about
0.6 percent, with a charge-off rate of about 1 percent. 

To provide a further assessment of the differences between the
profitability of credit card lending and commercial lending in the
period 1986 through 1993, we estimated another profit measure
commonly used for that purpose--return on equity (ROE).  Assuming
that credit card lending was at least 50-percent riskier than other
lending activities, as assumed in one study, we estimated that VISA
and MasterCard issuers earned an average ROE of 42.5 percent.\2 This
is about 4.5 times higher than the average ROE of 9.7 percent for
commercial banks in the same period. 


--------------------
\1 Robert E.  Litan, "Consumers, Competition, and Choice:  The Impact
of Price Controls on the Credit Card Industry," (Feb.  1992).  This
study was sponsored by MasterCard. 

\2 See the Robert E.  Litan study referred to earlier.  Assuming that
credit card lending is 50-percent riskier than other lending
activities, the Litan study estimated that credit card issuers needed
to maintain capital ratios at least 50-percent higher than for other
commercial bank lending activities.  Since commercial bank capital
ratios had averaged 6.6 percent--which was higher than the 6-percent
capital to asset ratio required by federal banking regulations for
banks to be considered adequately capitalized--Litan estimated that
credit card issuers need capital ratios of 10 percent.  Using Mr. 
Litan's assumption that credit card lending is at least 50-percent
riskier than other lending activities, we calculated the ROE estimate
of 42.5 percent by dividing the earnings as a percentage of average
outstanding balances for VISA and MasterCard issuers (4.25 percent)
between 1986 and 1993 by the 10-percent capital ratio (4.25/.1 = 42.5
percent). 


      UNIQUE CREDIT CARD LENDING
      COSTS MAY HAVE CONTRIBUTED
      TO STABLE INTEREST RATES
-------------------------------------------------------- Chapter 3:1.2

Some economists who explain stable interest rates partly in terms of
risk also believe that the industry's unique cost structure is a
factor in making credit card rates less responsive to changes in the
cost of funds, and therefore more stable, compared to interest rates
for other lending activities.  For example, they point out that
funding costs for credit card lending, as a percentage of total
lending costs, are low compared to other types of lending.  They
estimate that credit card funding costs are 25 to 50 percent of total
costs, while funding costs for other lending are 60 to 80 percent of
total costs.  Therefore, changes in funding costs provide issuers
less of a basis to change their credit card interest rates than
lenders who offer other types of loans. 

There are several reasons why funding costs represent a relatively
low percentage of total credit card costs.  As discussed earlier,
charge-off costs for credit card lending are comparatively high. 
Moreover, operating costs for credit card lending are also relatively
high.  For example, it has been estimated that the operating costs
for small banks that issued credit cards in 1991 were about 55
percent of their total credit card lending costs.  By contrast, these
banks' operating costs for other types of lending, such as home
mortgage and commercial lending, represented only about 20 percent of
the total costs for each of these lending activities.\3 One reason
that operating costs are higher for credit card lending is that
issuers must engage in a variety of ongoing activities to run
successful programs, such as soliciting new customers, servicing
accounts, and processing merchant credit card receipts.  Operating
costs are also relatively high because issuers must service a large
number of relatively small accounts--the average credit card balance
is only about $1,250. 

Another factor that has been mentioned as a potential cause of
interest rate stability is the tendency of funding costs and
charge-off costs to move in opposite directions during recessionary
periods.  Thus, to the extent that issuers may use lower funding
costs to offset higher charge-off costs, those savings would not be
available to pass on to the consumer in the form of reduced interest
rates.  For example, between 1989 and 1992--a period of economic
weakness in the United States--the average funding costs for VISA and
MasterCard issuers fell from about 8.73 percent of their average
outstanding balances to about 6.34 percent (a decrease of 2.39
percentage points).  During the same period, however, charge-offs as
a percentage of outstanding balances increased from 3.45 to 5.17
percent (an increase of 1.72 percentage points). 


--------------------
\3 These cost estimates are based on the Federal Reserve Board's
Functional Costs Analysis (FCA) program.  Under the FCA program,
banks throughout the country--who generally have less than $1 billion
in assets--voluntarily supply financial data for various lending
functions to the Federal Reserve.  The Federal Reserve uses a
standardized methodology to calculate revenue, expense, and
profitability ratios and publishes this data annually in aggregate
form. 


      THE LONG ECONOMIC EXPANSION
      OF THE 1980S MAY ALSO HAVE
      CONTRIBUTED TO STABLE
      INTEREST RATES AND HIGH
      EARNINGS
-------------------------------------------------------- Chapter 3:1.3

Federal Reserve economists have argued that the relatively high
credit card interest rates and earnings of the 1980s may have also
resulted in part from the unusually long economic expansion of that
period.  As card issuers widened their markets following the Supreme
Court decision in the Marquette case, these issuers may have expected
higher loan losses than normal, since they were extending cards to
riskier consumers.  For this reason, they may have incorporated a
high "risk premium" into the pricing of credit cards as reflected in
average interest rates around 18 percent.  However, the economic
expansion of the 1980s may have resulted in lower losses than
expected.  If issuers did overestimate potential losses in the 1980s,
average interest rates may decline in the future, according to the
Federal Reserve economists.\4

Economic theory regarding growing or maturing industries has also
been used to explain the strong earnings of credit card lending
during the 1980s.  Theoretically, when an industry is growing
rapidly, firms in that industry do not have to compete as much on
price to maintain their market shares because the expanding market
ensures business for all competitors.  Instead, they can maintain
prices at current levels and offer their products and services to a
larger customer base.  The growing demand for credit card loans
during the 1980s may have reduced issuers' incentives to offer lower
interest rates and contributed in this way to the industry's strong
earnings.  According to the maturing industry theory, as the growth
in credit card debt slows, competition should intensify, causing
issuers to lower their credit card interest rates to maintain their
market shares. 


--------------------
\4 Canner and Luckett, pp.  652-666. 


   OTHER EXPLANATIONS FOCUS ON
   CARDHOLDER BEHAVIOR
---------------------------------------------------------- Chapter 3:2

Analysts have also cited consumer and cardholder behavior as a
contributing cause of stability in credit card interest rates. 
According to these analysts, consumers' lack of responsiveness to
lower interest rates during the 1980s provided issuers with few
incentives to compete on this basis.  These analysts pointed out
that, for many cardholders, the costs associated with searching for
and switching to new credit cards outweighed the expected savings of
lower interest rates.  These costs may have been particularly high
for cardholders with low incomes and poor credit histories.  In
addition, consumers with good credit histories who intended to avoid
paying interest charges on their credit cards may have overextended
themselves and ended up paying interest charges.  These circumstances
could have allowed issuers to continue charging relatively high
interest rates and generating substantial earnings. 


      THE SEARCH COST THEORY
-------------------------------------------------------- Chapter 3:2.1

One common explanation economists have offered for cardholder
unresponsiveness to lower interest rates is based on the search cost
theory.  According to this theory, the costs of searching for
information about a product or service places limits on the amount of
information a consumer will obtain.  Because consumers may lack
information as a result of search costs, firms have less cause to be
concerned about whether their prices exceed the prices charged by
their competitors.  Consequently, firms have fewer incentives to
match those lower prices.  In the past, there have been several
potential sources of search costs in the credit card industry.  For
example, to obtain a credit card with a lower interest rate, a
cardholder had to contact a variety of issuers, collect information,
and compare the costs and benefits of each available card.  Recently,
more information has become available about credit card interest
rates and other pricing terms.  This development is discussed later
in this chapter. 

The willingness of consumers to search for information depends in
part on the benefits they anticipate and in part on the cost of the
search.  Consumers are more likely to search when purchasing a
big-ticket item, because search efforts could produce large savings;
they are also more likely to search when the cost of searching is
low.  Some analysts contend that for many cardholders, the benefits
of finding a lower rate card may not be worth the likely search
costs.  The average cardholder with an average balance of $1,250
would save about $40 a year by switching to a card with an interest
rate 3 percentage points lower than his or her current card.  Such
expected savings may not be sufficient to motivate cardholders--who
already value the service and convenience of their current
issuers--to seek cards that offer lower interest rates. 


      THE SWITCHING COSTS THEORY
-------------------------------------------------------- Chapter 3:2.2

A related explanation economists offer for cardholders' perceived
unresponsiveness to lower interest rates is based on the switching
costs theory that maintains that some cardholders are "tied" to their
current card issuer by the high costs of switching, or changing,
credit cards.  According to this theory, a change in credit cards
imposes prohibitive costs on many cardholders, particularly those who
carry over high balances relative to their incomes.  First,
cardholders who have established a good payment record (and thus have
high credit limits) may be reluctant to switch to a new card issuer
that may not initially give a comparable credit limit.  Also,
cardholders with large outstanding balances may find it difficult to
qualify for new cards, because the issuers may perceive them as
high-risk applicants.  They could be required to pay off and close
their existing accounts to qualify for the new card.  This could cost
them substantial time, effort, and money.\5

Research findings of Federal Reserve Bank of Philadelphia economists
are consistent with the view that higher switching costs of
high-balance cardholders contribute to the incentives issuers have to
maintain high interest rates and earnings.\6 In 1992, the economists
initiated an examination of the empirical significance of switching
costs for cardholders.  According to their preliminary study
findings, when cardholders with large balances applied for a card
from a new issuer, they were more likely than those with lower
balances to be turned down or be given a credit limit lower than the
one they requested.  The analysis, which held constant factors such
as income, sex, and age, was based on data from the 1989 Survey of
Consumer Finances. 

According to the economists, the only way for a card issuer to
attract cardholders from rival cards is to underprice those cards by
an amount substantial enough to at least compensate cardholders for
their switching costs.  In planning their marketing strategies,
issuers have to balance the cost of underpricing other cards against
the possible gain.  Even if the card issuer can increase its market
share by offering a sufficiently low rate, the potential gain from
this may not be sufficient to offset direct costs, such as marketing
expenses and reduced interest payments, from existing cardholders
(assuming that the lower rate also applied to them).  Thus, card
issuers with a large number of "tied" or "loyal" cardholders may not
be willing to compete on interest rates.  However, they may be
willing to offer various incentives such as frequent flyer miles to
attract creditworthy customers. 


--------------------
\5 Paul S.  Calem, "The Strange Behavior of the Credit Card Market,"
Business Review, Federal Reserve Bank of Philadelphia, (Jan./Feb. 
1992), pp.  3-13. 

\6 Paul S.  Calem and L.  J.  Mester, "Search, Switch Costs, and the
Stickiness of Credit Card Interest Rates," Working Paper No.  92-24,
(Dec., 1992). 


      SOME CARDHOLDERS MAY
      OVERESTIMATE THEIR ABILITY
      TO AVOID FINANCE CHARGES
-------------------------------------------------------- Chapter 3:2.3

Yet another explanation for consumers' apparent unresponsiveness to
lower interest rates is offered primarily by another economist who
claims that some cardholders may overestimate their ability to avoid
finance charges on their credit cards.\7 These cardholders intend to
take advantage of grace periods and avoid interest payments
altogether; however, despite these intentions, they overextend
themselves and end up paying interest on outstanding balances.  Card
issuers find these customers desirable because they borrow at high
interest rates, while posing little default risk. 

Federal Reserve economists, however, have questioned whether a class
of cardholders can be persistently wrong in anticipating the amount
of interest they pay over an extended period and be indifferent to
interest rates.  They argue that cardholders may overestimate their
ability to take advantage of grace periods and avoid interest
payments in the short run.  But, over time, their expectations are
likely to become more accurate as they realize the actual cost of
their behavior and become more responsive to interest rates.\8


--------------------
\7 Lawrence M.  Ausubel, "The Failure of Competition in the Credit
Card Market," American Economic Review, Vol.  81, No.  1 (Mar. 
1991), p.  70. 

\8 Canner and Luckett, pp.  652-666. 


   RECENT DEVELOPMENTS IN THE
   CREDIT CARD INDUSTRY
---------------------------------------------------------- Chapter 3:3

Several conditions that may have contributed to the stable interest
rates and high earnings of credit cards have changed during the
1990s.  In particular, the growth in credit card lending has slowed
in recent years, new card issuers have entered the industry,
consumers may have become more responsive to lower interest rates,
and the availability of information about credit card pricing terms
has increased.  A variety of issuers have offered many lower-risk
cardholders interest rates lower than 16.5 percent and have offered
higher-risk cardholders opportunities to borrow at lower rates under
specific conditions; however, some cardholders have continued to pay
rates higher than 18 percent. 


      GROWTH HAS SLOWED IN RECENT
      YEARS AND NEW CARD ISSUERS
      HAVE ENTERED THE INDUSTRY
-------------------------------------------------------- Chapter 3:3.1

The annual rate of growth of total outstanding credit card balances,
adjusted for inflation, fell from an average of 15.5 percent in the
period 1986-1990 to 5.1 percent in 1991 and remained flat in 1992. 
Several analysts we contacted said that the market was maturing and
the American public was "saturated" with credit cards.  As pointed
out in chapter 1, more than half of all households had at least one
credit card account in 1989, and nearly 90 percent of upper income
households (with incomes of $50,000 or more), presumably the most
desirable customer group, had at least one account.  These analysts
believed that existing issuers must compete more vigorously on
interest rates to maintain their market shares.  However, outstanding
credit card balances grew by 12.4 percent in 1993 as the economic
recovery strengthened.  Currently, it is unclear whether the growth
in outstanding balances will continue at double-digit rates.\9

Moreover, several major nonbank corporations have entered the credit
card industry.  According to the SMR Research Corporation--a firm
that tracks developments in the industry--these nonbank entrants may
be more comfortable than depository institutions with lower interest
rates and earnings because their primary reason for issuing credit
cards was to increase volume in their traditional lines of
businesses.  For example, in its 1992 offering of its new credit
card, General Motors offered rebates on the purchase of its vehicles,
an interest rate of 16.4 percent, and no annual fee.  These
incentives encouraged 7 million consumers to accept the General
Motors credit card in its first year on the market. 

The industry expanded into new markets as the growth in traditional
lending slowed and new entrants have begun to issue cards.  For
example, VISA and MasterCard have tried to expand the use of credit
cards as the normal means of payment for activities such as purchases
in grocery stores and services from health care providers.  The two
associations have also developed systems to process "debit-card"
transactions.  Unlike credit cards, for a fee debit cards
automatically deduct the purchase price from a cardholder's checking
or savings account at the point of sale.  VISA and MasterCard believe
that debit cards will benefit their members in the future because of
their increasing popularity among consumers and merchants as a
payment device. 


--------------------
\9 According to the RAM Research Corporation, most of the growth in
credit card balances in 1993 occurred during the latter half of the
year.  During the first 6 months of 1993, the growth in outstanding
balances was essentially flat on an inflation-adjusted basis. 


      CONSUMERS MAY HAVE BECOME
      MORE RESPONSIVE TO INTEREST
      RATES AND IMPROVED
      INFORMATION IS AVAILABLE
-------------------------------------------------------- Chapter 3:3.2

A variety of industry reports in the early 1990s indicated that
consumers were increasingly concerned about credit card debt and
interest rates.  The reports attributed the increase in concern to
the (1) excessive borrowing of cardholders who obtained credit cards
for the first time in the 1980s, (2) many credit card defaults and
delinquencies caused by the economic downturn of the early 1990s, and
(3) 1986 phase out of tax deductions for credit card interest
payments.  According to these reports, cardholders are more
interested in retiring their existing debt than incurring new debt,
and motivated to find credit cards that offer relatively low interest
rates.  The tax law changes have prompted many consumers to make use
of home equity lines of credit, because interest payments on these
loans remain tax deductible. 

Congressional attention to credit card competition has also focused
consumers on interest rates.  For example, in November 1991 when the
Senate passed an interest rate cap, the media gave widespread
coverage to the event.  As a result, many consumers became more aware
of the interest rates they were paying and were more willing to seek
competitively priced credit cards, according to credit card industry
reports. 

In the early 1990s, improved information about interest rates and
other credit card pricing terms was available to consumers willing to
shop for credit cards.  The increase in available information is
partly because of the passage of the Fair Credit and Charge Card
Disclosure Act of 1988.  Among other provisions, this act requires
card issuers to provide readily understandable information in all
card solicitations about their interest rates, annual fees, and grace
periods.  This information is typically presented in a table in
credit card solicitations.  The act also required the Federal Reserve
to collect data on credit card price and availability from a broad
sample of financial institutions offering credit card services.  The
data must be publicly available and must be reported to Congress
semiannually.  The Federal Reserve has complied with these
requirements by semiannually reporting data on the most common
interest rates, annual fees, and other pricing terms offered by a
sample of card issuers.  (Before these amendments, cardholders
sometimes did not obtain full disclosure of these credit card terms
until their applications were approved.) Finally, the act requires
the Federal Reserve to report to Congress annually on its assessment
of the profitability of credit card lending. 

In addition to the Federal Reserve, the Nilson Company, the RAM
Research Corporation, Bankcard Holders of America, and other
organizations published periodic information about the pricing terms
offered by a variety of credit card issuers.  Stories that discuss
credit card interest rates have appeared in both national and local
newspapers, magazines, and television and radio broadcasts. 


      CARD ISSUERS HAVE RESPONDED
      TO CHANGES BY OFFERING LOWER
      INTEREST RATES
-------------------------------------------------------- Chapter 3:3.3

Many credit card issuers have responded to these competitive
developments by offering lower interest rates to creditworthy
customers who represent lower default risks.  For example, Citibank,
the largest issuer as measured by outstanding balances, offers some
of its customers who have good credit histories a card with a
promotional rate of 6.9 percent and no annual fee.  Several regional
issuers have also offered credit card terms designed to be
competitive.  For example, in 1992, Wachovia Bank in North Carolina
offered a credit card with an interest rate of 8.9 percent and a $39
annual fee to selected customers.  Wachovia officials estimated that
the offering increased the bank's outstanding credit card balances by
about 7.6 percent (approximately $2.2 billion at yearend 1992).  Many
issuers have also started to offer "balance transfer" programs to
encourage credit card switching by qualified, low-risk prospective
cardholders.  These issuers include blank checks with their
solicitations to enable recipients to close out their existing credit
card accounts and move their outstanding balances to the new card. 

These recent lower interest rate credit card offerings have clearly
benefited many cardholders.  By December 31, 1992, the percentage of
total credit card balances subject to annual interest rates of less
than 16.5 percent was 41 percent--nearly seven times the total
balances with such rates in 1990 (see table 3.1).  However, the
reduction in rates has not been universal because, at yearend 1992,
40.1 percent of outstanding balances were subject to annual interest
rates exceeding 18 percent.  The cardholders paying the highest rates
may well be those who overestimate their ability to avoid finance
charges for short periods, those who continue to be unresponsive to
rates because of search and switch costs, and those who have credit
history problems.  The data may also include credit cardholders who
pay their balances in full each month, and therefore are indifferent
to interest rate levels.\10 There are no data presently available
that would allow us to make determinations as to what percentage of
cardholders fall into each category. 



                                    Table 3.1
                     
                       Credit Card Outstanding Balances by
                            Interest Rates, 1990-1992


In
te
re
st
ra
te
gr                Percent of                Percent of                Percent of
ou      Balance        total      Balance        total      Balance        total
p        amount      balance       amount      balance       amount      balance
--  -----------  -----------  -----------  -----------  -----------  -----------
Un        $10.3         6.1%        $13.2         7.4%        $76.5        41.4%
 d
 e
 r
 1
 6
 .
 5
 %
16         34.4         20.5         40.4         22.6         34.3         18.5
 .
 5
 %
 -
 1
 8
 .
 0
 %
Ab        123.2         73.4        125.2         70.0         74.2         40.1
 o
 v
 e
 1
 8
 .
 0
 %
================================================================================
To       $167.9       100.0%       $178.8       100.0%       $185.0       100.0%
 t
 a
 l
--------------------------------------------------------------------------------
Source:  RAM Research Corporation.  The data are based on a survey of
about 250 depository institution card issuers.  The surveyed issuers
account for about 90 percent of outstanding card balances. 


--------------------
\10 These cardholders tend to be more responsive to annual fees,
credit limits, and enhancements such as frequent flyer miles, rather
than to changes in the annual interest rates. 


      OPPORTUNITIES TO QUALIFY FOR
      LOWER INTEREST RATES
-------------------------------------------------------- Chapter 3:3.4

Some card issuers have offered special programs for cardholders who
have not qualified for lower rates on the basis of good credit
histories.  Under these programs, such cardholders may qualify in
time for lower rates through charge and payment performance.  Through
the Discover Card, for example, Sears (now Dean Witter) provided
opportunities for cardholders with interest rates of 19.8 percent to
qualify for a 14.9 percent rate if they charge at least $1,000 within
a year and were not late on two consecutive payments.  American
Express offers similar incentives to its Optima cardholders to expand
its market share and the quality of its cardholder accounts.  In
addition, some individuals who represent higher default risks and may
not otherwise be able to obtain credit cards can qualify for
"secured" credit cards.  To qualify for a secured card, a customer
pledges cash deposited in a savings account as collateral for credit
extended by the issuer. 


   COMPETITIVE DEVELOPMENTS IN THE
   INDUSTRY NEED TO BE CLOSELY
   MONITORED
---------------------------------------------------------- Chapter 3:4

Although many cardholders, particularly those who represent lower
default risks, are clearly benefiting from cards that offer lower
interest rates, we believe recent developments in the industry must
be closely monitored to determine whether the apparent increase in
competitiveness is sustained.  There are certain issues and potential
limitations to the recent developments that are important to
understanding the future competitiveness of the industry.  However,
the ability of Congress and industry analysts to monitor these recent
developments is limited because the Federal Reserve does not collect
and publish sufficient information about available credit card
interest rates.  The Federal Reserve is considering taking steps to
address this issue by collecting additional information on credit
card interest rates. 


      POTENTIAL LIMITATIONS TO
      RECENT DEVELOPMENTS
-------------------------------------------------------- Chapter 3:4.1

Since many of the recent offerings are credit cards with variable
interest rates tied to the prime rate, credit card interest rates can
be expected to rise if the prime rate increases.  Moreover, the
recent price competition among issuers will not necessarily result in
reduced earnings over the short term because of the sharp decline in
funding costs in recent years.  The industry's pretax earnings as a
percent of outstanding balances reached 4 percent in 1992 and 4.53
percent in the first 9 months of 1993, partly because of record low
funding costs, after falling to 3.55 percent in 1991.  The difference
between credit card interest rates and funding costs remained at
relatively high levels in 1993 despite the recent competition among
issuers.\11 While in the long term economists would expect earnings
to fall because of increased price competition among existing issuers
and nonbank entrants, earnings may remain at relatively high levels
if funding costs remain low.  Issuers who offer relatively low
interest rates could also compensate for the lost revenue by actions
such as limiting the period of time that introductory interest rates
apply, raising annual fees, imposing other charges or fees for late
payments and cash advances, and shortening grace periods. 

The potential also exists that certain cardholders, particularly
those who represent higher default risks, will not be afforded the
opportunity to take advantage of programs designed to lower their
credit card borrowing costs.  Although it is logical for issuers to
charge higher interest rates to these types of cardholders, they may
continue to pay historically high rates (exceeding 18 percent)
because they are "tied" to their current issuers.  Moreover, because
they are "tied" to their current issuers, these issuers will have
incentives to continue charging them relatively high interest rates
even though funding costs have declined. 

Finally, lower interest rates may not be a trend that will continue. 
During the mid-1980s, some issuers--including Manufacturer's Hanover
and Chase Manhattan--announced offerings of relatively low interest
rates during an earlier period of widespread congressional, media,
and public scrutiny of the industry's pricing practices.  However,
average interest rates remained stable at 18 percent, and by 1990,
after scrutiny of the industry's pricing practices had subsided,
Chase Manhattan and Manufacturer's Hanover had resumed charging the
19.8 percent most common rate charged by other large issuers. 


--------------------
\11 As discussed in chapter 1, in 1993, the difference between the
average most common interest rate of 16.83 percent and credit card
funding costs reached 11.50 percentage points in 1993, the highest
level since 1976. 


      THE FEDERAL RESERVE CAN
      EXPAND ITS REPORTING ON
      COMPETITIVE DEVELOPMENTS IN
      THE CREDIT CARD INDUSTRY
-------------------------------------------------------- Chapter 3:4.2

We believe the Federal Reserve can assist Congress and industry
analysts in monitoring competitive developments in the credit card
industry by collecting a wider variety of information about credit
card pricing activity.  As discussed in chapter 1, the Federal
Reserve currently collects and publishes information about the "most
common" credit card interest rates charged by a sample of banks. 
This information does not capture the diversity of card terms that
individual issuers offer to their customers, particularly interest
rates offered to the most creditworthy cardholders.  Therefore, the
information does not permit analysts to assess the extent to which
different types of customers--on the basis of their perceived credit
risk--are benefiting from lower rate card offerings.  Although
private organizations like RAM Research collect some information on
the range of available interest rates (see table 3.1), this
information is generally provided only to those who pay for
subscriptions, although the media has drawn upon it for periodic
articles and broadcasts about the industry.  During our review, a
Federal Reserve official said that the organization recognizes the
need for additional information on the extent to which the recent
price competition among card issuers is affecting cardholders, and
that it would try to collect and publish more interest rate
information on a voluntary basis to minimize industry reporting
costs. 

The Federal Reserve could also provide this additional information in
its annual report to Congress on credit card profitability, which is
required by the Fair Credit and Charge Card Disclosure Act of 1988. 
As required by the act, the Federal Reserve has issued the
profitability report since 1990.  Among other issues, these reports
have commented on the profitability of large and small credit card
issuers, the competitive structure of the industry, and the impact of
new disclosure requirements on the industry.  In our view, these
reports could also serve as a forum for the Federal Reserve to
comment on the extent to which the recent offerings of lower interest
rate cards are (1) benefiting cardholders who represent varying
degrees of credit risk and (2) affecting the industry's earnings.  In
the profitability reports, the Federal Reserve could also comment on
other issues that affect industry competition such as the potential
for tacit coordination, barriers to entry issues raised in the
ongoing Dean Witter-VISA litigation, and the state of intersystem
competition.  This information could help Congress and industry
analysts better monitor and assess the competitive performance of the
U.S.  credit card industry over the short and long term. 


   CONCLUSIONS
---------------------------------------------------------- Chapter 3:5

The contrast between stable credit card rates and fluctuating
interest rates for other types of lending has prompted widespread
concern about the pricing practices of the credit card industry.  We
believe that some, but perhaps not all, of the concerns that have
been raised may be alleviated by a better understanding of the credit
card industry.  Expecting credit card interest rates and interest
rates charged on other consumer loans to rise and fall in a parallel
manner with the cost of funds is to assume that the two types of
lending are more alike than they actually are. 

We agree with many analysts that the risks of unsecured credit card
lending are greater than those of most other types of consumer loans
and can help explain the stable credit card interest rates of the
1980s.  However, we do not believe that the differences in risk alone
provide a complete explanation.  The unique cost structure of the
credit card industry also helps explain the stability of credit card
interest rates.  Because credit card funding costs are relatively
low, credit card interest rates are likely to be somewhat less
sensitive to changes in the cost of funds compared to rates for other
types of consumer lending.  During the 1980s, card issuers may also
have built "risk premiums" into their pricing as they offered credit
cards to riskier customers, and the expanding demand for credit card
loans may have reduced issuers' incentives to offer lower interest
rates.  Analysts have also commented that, in the past, consumers'
failure to shop for cards that offered lower interest rates--because
of search and switch costs--permitted issuers to maintain interest
rates and earnings at relatively high levels. 

Several of the conditions that may have contributed to stable and
high earnings changed in the 1990s.  The reduced growth in
outstanding credit card balances in 1991 and 1992, along with new
industry entrants, most likely increased competitive pressures within
the credit card industry.  In addition, improved information about
credit card terms and conditions, and heightened public awareness of
industry pricing practices may promote greater consumer
responsiveness to interest rates, especially among creditworthy
consumers who are eligible for the lower rate cards.  This, in turn,
may encourage more issuers to offer lower rate cards. 

Despite the lower interest rates on some cards offered in 1992 and
1993, we believe that the U.S.  credit card industry's performance
should still be closely monitored to determine whether the apparent
increase in competition is sustained over the short and long term. 
Industry earnings remained high throughout 1992 and 1993 partly
because of record low funding costs.  Also, for various reasons, some
cardholders may not be able to take full advantage of lower cost
cards and may continue to pay interest rates exceeding 18 percent. 
Close monitoring is also warranted because the recent competition
among issuers could lessen if congressional, media, and public
scrutiny of the industry's pricing practices subsides.  The Federal
Reserve is already planning to increase the information it gathers
about issuers' credit card offerings, and it could use the
information, along with other information, to expand its annual
reporting to assist Congress in monitoring competitive developments
in the credit card industry. 


   RECOMMENDATIONS
---------------------------------------------------------- Chapter 3:6

We recommend that the Chairman of the Federal Reserve (1) collect
additional information on credit card interest rates that permits an
assessment of the extent to which cardholders are benefiting from
lower credit card interest rates and an assessment of how these rates
affect industry earnings and (2) assess the short- and long-term
impacts of competitive developments within the industry.  We also
recommend that the Chairman of the Federal Reserve incorporate this
information and analysis in the annual report to Congress on industry
profitability to assist Congress in making informed public policy
decisions. 


   AGENCY COMMENTS AND OUR
   EVALUATION
---------------------------------------------------------- Chapter 3:7

We provided copies of a draft of this report to the Attorney General
and the Chairman of the Federal Reserve for their review and comment. 
Although the Attorney General chose not to provide written comments,
Department of Justice Antitrust Division officials told us in March
1994 that they generally agreed with its analysis and conclusions. 

The Chairman of the Federal Reserve said the report is a
comprehensive and well-documented analysis of competitive
developments in the credit card industry (see app.  II).  The
Chairman agreed with our recommendations and described the additional
information that the Federal Reserve plans to collect on credit card
interest rates and the expanded analysis it plans to include in its
annual report to Congress.  We believe these actions will provide
improved information about the extent to which cardholders are
benefiting from offers of lower interest rates.  In addition, the
Chairman said the Federal Reserve believes that the credit card
industry is competitive and that, in recent years, issuers have
adopted variable rate pricing strategies that more explicitly track
changes in market interest rates.  The Chairman also provided some
technical comments that have been incorporated in the report. 

However, the Chairman did take issue with our statement in the draft
that the adequacy of available information published by the Federal
Reserve limits the ability of Congress and analysts to assess recent
competitive developments in the industry.  He said such information
is available from a variety of private-sector sources.  The report
has been clarified on page 43 to state that our concern relates only
to the adequacy of information on the range of interest rates that
issuers offer to their cardholders.  We believe this concern will be
addressed by the Federal Reserve's plans to collect additional
information about credit card interest rates. 


ANALYSIS OF POLICY OPTIONS
============================================================ Chapter 4

Since the mid-1980s, Congress has considered several public policy
options in response to the stability of average credit card interest
rates and the relatively high earnings of the industry.  One proposed
policy option was to impose a nationwide cap on credit card interest
rates.  The basic argument for such a cap was that interest rates
were too high because of inadequate competition and that government
intervention was necessary to lower rates, protect consumers, and
stimulate the economy.  Opponents of the proposal argued that the
government should maintain a nonintervention policy because the
industry is becoming increasingly competitive, and an interest rate
cap would harm the economy by compelling issuers to cancel the cards
of many individuals who represent higher credit risks.  A third
policy option was for the government to encourage more consumer
responsiveness to credit card interest rates through additional
disclosure requirements.  Although we are not recommending any of
these policy options, this chapter discusses some of their advantages
and disadvantages. 


   POLICY OPTION 1:  ESTABLISH A
   NATIONWIDE CAP ON CREDIT CARD
   INTEREST RATES
---------------------------------------------------------- Chapter 4:1

On several occasions since 1985, Congress has considered enacting a
national cap on credit card interest rates to address alleged
deficiencies in competition within the industry.  As discussed
earlier in this report, in November 1991, the Senate passed a measure
that would have imposed a variable interest rate cap of 14 percent,
but the legislative session ended before an interest rate cap was
considered by the House of Representatives.  The bill set the maximum
allowable interest rate at 4 percentage points above the Internal
Revenue Service penalty rate, which was 10 percent in 1991.\1 This
bill generated considerable controversy in Congress and among
industry participants, consumer groups, and the public. 

Interest rate caps, such as the one debated in 1991, have generally
been proposed to protect consumers from credit card interest rates
that were viewed as unnecessarily high and as a means to stimulate
the economy.  Proponents of the 1991 bill argued that the failure of
credit card interest rates to fall despite significant declines in
both funding costs and the interest rates of other lending activities
showed that the industry was not performing competitively.  Earnings
higher than those that would prevail in a more competitive market in
effect redistribute income away from lower-income to higher-income
individuals.  Proponents also argued that if credit card interest
rates were lower, more people would borrow to purchase goods and
services, and this would have the effect of stimulating the economy. 

Some analysts also pointed out that, despite the risks associated
with credit card lending and high charge-offs, issuers still generate
relatively high earnings.  Consequently, it could be argued that
issuers could still generate reasonable earnings even if Congress
passed an interest rate cap.  For example, one well-known financial
commentator has argued that if Congress established an interest rate
cap that exceeded the federal funds rate\2 by 10 percentage points,
efficient credit card issuers would still generate reasonable
earnings.\3


--------------------
\1 The penalty rate, the rate the IRS charges to citizens who are
delinquent on their taxes, is set at 3 percentage points above the
average yield on Treasury securities with maturities of 3 years or
less. 

\2 The federal funds rate is the rate charged in the interbank market
for excess reserve balances and was about 3 percent for much of 1992
and 1993.  Therefore, a credit card interest rate cap set 10
percentage points above such a federal funds rate would be 13
percent. 

\3 Martin Mayer, "Counterpoint," The Wall Street Journal, (Nov.  21,
1991). 


      EVIDENCE SUGGESTS THAT A CAP
      COULD LEAD TO RESTRICTIONS
      ON CREDIT CARD LENDING
-------------------------------------------------------- Chapter 4:1.1

Opponents of government intervention in the credit card industry
argue that an interest rate cap would be counterproductive and could
have unintended consequences.  In particular, they argue that if
issuers determine that an interest rate cap did not permit them to
recover their full cost of operations, they would respond by
canceling the cards of customers who represented their greatest
default risks.  These cardholders are typically younger individuals
with high debt levels and relatively low income levels. 

Several studies indicate that an interest rate cap, depending upon
the level it is set, would lead issuers to tighten their lending
criteria.  A 1981 study published by the Credit Research Center at
Purdue University examined the lending criteria of credit card
issuers in Arkansas, which at the time had a usury ceiling of 10
percent.  The Credit Research Center found that issuers located in
Arkansas were more likely than issuers in most other states to
restrict their cardholder base to upper-income individuals.\4 The RAM
Research Corporation has found that credit card issuers with
headquarters in Arkansas reject 80 to 90 percent of all applications,
restrict new customers to relatively low credit limits of $800 to
$1,000, and charge annual fees as high as $35.  In addition, a recent
industry-sponsored study estimated that issuers would cancel the
credit cards of as many as 32 million cardholders if Congress passed
a rate cap of 14 percent as proposed in the recent Senate bill.\5

Historical experience also suggests that an interest rate cap could
result in a tightening of credit standards.  Many states had usury
laws in place until they were repealed or relaxed in the early 1980s. 
Several economists argue that the deregulation of credit card
interest rates encouraged issuers to offer cards to riskier potential
customers who previously did not qualify.  Such customers are
generally believed to be the most vulnerable to cancellation of their
cards in the event of any new, federally imposed interest rate cap. 

Moreover, issuers could respond in several other ways to maintain
their earnings if Congress establishes an interest rate cap.  In
particular, they could raise cardholders' annual fees, increase the
fees to merchants for accepting credit cards, tighten credit limits,
shorten or eliminate grace periods, and eliminate enhancements.  Many
issuers instituted annual fees for the first time in the early 1980s
as a result of sharp rises in funding costs during the late 1970s and
early 1980s that, with state usury laws, prevented issuers from being
able to recover the full cost of their credit card operations through
interest charges. 


--------------------
\4 William C.  Dunkelberg, et al., CRC 1979 Consumer Financial
Survey, Monograph No.  22 (1981), Credit Research Center, Krannet
Graduate School of Management, Purdue University. 

\5 Robert E.  Litan, Consumers, Competition, and Choice:  The Impact
of Price Controls on the Credit Card Industry, (Washington, D.C.: 
Feb.  1992). 


      POTENTIAL EFFECTS ON THE
      MARKET FOR SECURITIES BACKED
      BY OUTSTANDING CREDIT CARD
      BALANCES
-------------------------------------------------------- Chapter 4:1.2

An interest rate cap that does not permit issuers to fully recover
their costs could also have negative implications for the
securitization programs of many issuers--through which a number of
large issuers convert credit card balances to securities and sell
them.  Since 1987, several large issuers have placed a portion of
their outstanding credit card balances into trusts.  In turn, the
trusts issue securities that are sold to investors.  Typically, the
issuer retains a portion of the interest and fee income generated
from the "securitized" balances to service the accounts and build a
reserve fund to protect investors against losses.  The investors who
purchase the securities receive interest income that usually exceeds
the yields on short-term Treasury notes.\6 These securities are
traded on secondary markets and are primarily held by large
institutions such as banks, insurance companies, and pension funds. 
At yearend 1992, the level of securities backed by credit card
outstanding balances issued by large commercial banks had reached $64
billion, according to a Federal Reserve official. 

Issuers have securitized their credit card balances for a variety of
reasons.  In particular, securitization permits depository
institutions that issue credit cards to more easily meet federally
imposed capital standards because they generally do not have to hold
capital against credit card balances that have been securitized.  In
addition, issuers can use the proceeds from the sale of these
securities to build capital, pay dividends, and to fund additional
lending. 

A federally imposed interest rate cap could also increase investors'
risks.  According to an official at Moody's Investors Services, many
securitized transactions have built-in investor protections that,
under certain conditions, require issuers to pay back investors'
principal before the securities mature.  For example, if charge-offs
exceed predetermined levels--say 7 percent of the securitized
balances--the issuer must automatically repay the principal on
outstanding balances.  An interest rate cap could also trigger
automatic repayment because it could reduce issuers' revenues from
interest charges and thereby limit their ability to pay operational
and charge-off costs.\7 While such prepayments permit investors to
recover their principal, they may have to reinvest the principal in
investments that have lower interest rates.  Thus, an interest rate
cap may diminish the value associated with holding securities backed
by credit card balances.  According to industry reports, when the
Senate passed legislation imposing a credit card interest rate cap of
14 percent in 1991, trading in securities backed by outstanding
credit card balances halted. 


--------------------
\6 An official at Moody's Investors Services said that a "generic"
securitized transaction might be structured in the following way. 
Assuming that the balances yield 18 percent, 6 percent would be paid
to the investors, 7 percent would be set aside to cover losses, and 2
percent would be used to service the accounts (i.e., bill customers),
which totals 15 percent.  The issuing institution would retain the
remaining 3 percent, which is sometimes referred to as "excess"
servicing costs. 

\7 Using the "generic" security transaction described in footnote 6,
an interest rate cap of 14 percent would limit the issuers' ability
to cover losses or pay operating expenses, which in this example
totaled 15 percent, and would trigger automatic repayment provisions. 


   POLICY OPTION 2:  ALLOW THE
   CREDIT CARD MARKET TO DETERMINE
   INTEREST RATE LEVELS
---------------------------------------------------------- Chapter 4:2

Another policy option is for Congress to avoid intervention in the
credit card market, permitting market forces to determine interest
rates.  Proponents argue that the industry is, in fact, performing
competitively and that competition is increasing.  They also argue
that a nonintervention policy would avoid risks associated with an
interest rate cap, particularly the cancellation of many credit
cards. 

Evidence that the market is performing competitively includes the
number of issuers in the market, the acceptable levels of
concentration, and lower interest rates offered by major issuers in
1992 and 1993.  Proponents of nonintervention also point to the entry
of large nonbanks as evidence of increasing industry competition. 
Another factor pointing to increasing competition is that consumers
who may have found search costs prohibitive in the 1980s were
receiving improved information about interest rates, annual fees, and
grace periods in the early 1990s.  This information has been made
available through requirements of the Fair Credit and Charge Card
Disclosure Act of 1988 and through various other media and
organizations that follow the industry. 

On the other hand, several limitations to the recent competitive
developments could be used to justify an interest rate cap.  For
example, two large issuers lowered their interest rates in the
mid-1980s during a period of congressional scrutiny of the industry's
pricing practices, but raised their interest rates later in the
decade.  Intervention may also be justified to provide relief to
riskier cardholders who, because they are "tied" to issuers charging
high rates, may not benefit from the lower rates offered in 1992 and
1993.  Further, since most issuers have pegged their new low-rate
cards to the prime rate, credit card interest rates will increase
when the prime rate increases. 


   POLICY OPTION 3:  FURTHER
   STRENGTHEN DISCLOSURE
   REQUIREMENTS
---------------------------------------------------------- Chapter 4:3

In recent years, several proposals have been made to strengthen the
provisions of the Fair Credit and Charge Card Disclosure Act of 1988
to provide more information to consumers.  One legislative proposal
designed to strengthen the act would require issuers to print tables
that show their credit card pricing terms on the envelopes used in
mail solicitations.  Moreover, Bankcard Holders of America (BCHA), a
cardholder advocacy group, has argued that consumers need more
information about issuer pricing practices.  For example, a study by
BCHA found that some issuers charge much higher rates for cash
advances than for purchases and do not disclose this information in
their solicitations.\8 BCHA believes that issuers should disclose the
interest rate for cash advances.  In addition, BCHA has argued that
some issuers use deceptive billing calculation methods that can
result in excessively high interest charges to consumers.  BCHA has
advocated these billing practices should be banned. 

By reducing search costs, further disclosure requirements may benefit
consumers who are willing to shop around for new cards and can
qualify for lower rates.  Several analysts have commented that the
Fair Credit and Charge Card Disclosure Act of 1988 and increased mass
mailings and publicity about the industry have probably lowered
consumer search costs in recent years.  The proposals cited above,
and others, may reduce search costs even more.  However, new
disclosure requirements would not necessarily benefit cardholders
whose credit histories prevent them from taking advantage of more
attractive credit card offerings. 

New disclosure laws would also impose some additional regulatory
costs on credit card issuers.  For example, any changes to current
disclosure requirements will require issuers to redesign their
solicitations, notices, billings, and possibly their envelopes. 
Critics of such disclosure requirements could argue that they raise
costs on the credit card industry without necessarily benefiting
consumers.  However, the Federal Reserve, when commenting on similar
disclosure requirements for the Fair Credit and Charge Card
Disclosure Act of 1988, pointed out that such redesign costs are not
necessarily substantial.  These costs are typically one-time expenses
associated with changing solicitation notices to reflect new
disclosure requirements.\9 Therefore, any effort to strengthen
disclosure laws would require careful consideration of whether
customers would benefit and the costs credit card issuers would
incur. 


--------------------
\8 Bankcard Holders of America, "Credit Cards:  What You Don't Know
Can Cost You." (June 18, 1992). 

\9 Board of Governors of the Federal Reserve System, "Annual Report
on the Profitability of Credit Card Operations of Depository
Institutions," (1990). 


HOW A TYPICAL CREDIT CARD
TRANSACTION WORKS
=========================================================== Appendix I

A typical credit card transaction involves the cardholder, the
merchant, the merchant's bank, VISA or MasterCard, and the depository
institution that issued the credit card (see figure I.1).\1 In most
cases, the merchant will seek authorization for the purchase from the
cardholder's bank via a computer hook-up provided by VISA or
MasterCard or an independent company such as Nabanco.  The issuing
bank maintains information on the cardholder's credit limit and can
authorize a transaction in as little as 2 seconds, according to a
VISA official. 

During the processing of credit card transactions, fixed fees are
charged to the merchant, the merchant's bank, and the card issuer. 
The merchant's bank subtracts a "discount" fee of 1.9 percent of the
total purchase price as compensation for providing credit card
processing services to the merchant.\2 An "interchange" fee of 1.3
percent of the total purchase price is paid to the depository
institution that issued the credit card.  Finally, VISA and
MasterCard charge fixed processing fees to the merchant bank and the
card issuers for using their computerized transaction settlement
systems. 

   Figure I.1:  Payment Flows in a
   Typical Credit Card Transaction

   (See figure in printed
   edition.)

   Note:  Sears and American
   Express developed their own
   systems to process Discover and
   Optima credit card
   transactions.

   (See figure in printed
   edition.)

   Source:  VISA, MasterCard, and
   the New York Times .

   (See figure in printed
   edition.)



(See figure in printed edition.)Appendix II

--------------------
\1 VISA and MasterCard have authorized certain of their
members--often called merchant banks--to sign-up merchants to accept
their credit cards and to service their accounts.  Certain
independent companies, such as Nabanco, compete with VISA and
MasterCard members in providing credit card processing services to
merchants. 

\2 Based on MasterCard's fee schedule.  VISA has established similar
fees. 


COMMENTS FROM THE CHAIRMAN OF THE
FEDERAL RESERVE
=========================================================== Appendix I

Now on pp.  43, 45, 48



(See figure in printed edition.)

Now on p.  47

Now on p.  47



(See figure in printed edition.)


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix III


   GENERAL GOVERNMENT DIVISION,
   WASHINGTON, D.C. 
------------------------------------------------------- Appendix III:1

Wesley M.  Phillips, Deputy Project Manager
Mitchell B.  Rachlis, Senior Economist
Desiree Whipple, Reports Analyst
Hazel Bailey, Writer-Editor
Phoebe Jones, Secretary


   OFFICE OF THE CHIEF ECONOMIST
------------------------------------------------------- Appendix III:2

Yesook Merrill, Project Manager
Jim White, Senior Economist
Mark Turner, Program Review Analyst


   OFFICE OF THE GENERAL COUNSEL
------------------------------------------------------- Appendix III:3

Maureen A.  Murphy, Senior Attorney


BIBLIOGRAPHY
=========================================================== Appendix 1

Ausubel, Lawrence M.  "The Failure of Competition in the Credit Card
Market." American Economic Review, Vol.  81, No.  1 (Mar.  1991), pp. 
50-81. 

Balto, David A.  "Antitrust and Credit Card Joint Ventures." Consumer
Financial Law Quarterly Report.  (Spring 1993), pp.  266-272. 

Bankcard Holders of America.  Credit Cards:  What You Don't Know Can
Cost You.  Herndon, Va., June 1992. 

Berlin, Mitchell and Loretta J.  Mester.  Credit Card Rates and
Consumer Search.  Federal Reserve Bank of Philadelphia, July 1992. 

Bernard, Jules.  "New Directions in BankCard Competition." Catholic
University Law Review, Vol.  30:65 (1980), pp.  65-102. 

Board of Governors of the Federal Reserve System, "Annual Report on
the Profitability of Credit Card Operations of Depository
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