The unintended consequences of interest rate caps

Last week, Sen. Bernie Sanders (I-Vt.) and Rep. Alexandria Ocasio-Cortez (D-N.Y.) introduced the Loan Shark Prevention Act amid a litany of references to executive compensation, payday lenders and credit card “rip offs.”

They even invoked the Bible’s admonitions against usury. The bill would create a nationwide 15-percent annual percentage rate (APR) cap on interest rates on all consumer lending and credit cards purportedly to put money back in consumers’ pockets. 

The concept sounds great. Frankly, no one likes high interest rates. Commentators of various political persuasions have applauded it.

Unfortunately, actions that politicize and regulate one aspect of a competitive market rarely have ever worked. More frequently, they have caused even greater financial pain and credit dislocation.

The sponsors highlight the apparent unfairness of a median credit card interest rate of 21.36 percent, while the economy is still comfortably nestled in a low-interest-rate environment.

In response, the bill adopts the provisions of another law already on the books that has limited the interest rate on credit union consumer loans and credit cards to 15-percent APR.

That rate can be modified if the appropriate federal regulator decides to do so after “consultation” with the appropriate committees of the Congress, the Department of Treasury and other federal bank regulatory agencies. 

Sanders and Ocasio-Cortez suggest that the record of demonstrated success of this 15-percent cap on credit union lending over the last several decades should be replicated for all consumer lending. 

Unfortunately, credit unions have almost never lived under this 15-percent cap. Their regulator eliminated it in 1987, replacing it with an 18-percent rate in effect today. The exception for payday-type lending hovers around 28 percent.

Credit unions are inadequate models for the feasibility of interest rate caps on all consumer lending throughout the nation. U.S. credit unions together are about one-half the size of J.P. Morgan. Moreover, credit unions don’t pay federal income tax, a government subsidy that allows them to charge lower interest rates. 

If exemption from federal income taxes in return for an interest rate cap that bank regulators could modify were also on the table, perhaps banks and credit card companies might be willing to participate in that conversation.

The larger problem is that interest rate caps have rarely ever worked. In a competitive system, interest rates reflect a variety of financial factors, including credit history, customer defaults,  transaction size, credit limits, rewards programs, collection proceedings and fraud. Median credit card rates also tend to obscure the real facts.

As the bill’s sponsors effectively acknowledge, anyone can go online to compare the terms offered by dozens of credit card issuers to decide which best fits their financial situation. I did just that. 

Credit card issuers are currently offering rates online as low as 8.5 percent for a variable-rate credit card and higher APR cards that vary based on terms, credit limits, rewards programs and the applicant’s credit history.

Most cards provide 30 days of free credit if the statement is paid on time, a feature that might disappear, along with rewards programs, if interest rate caps were created. 

The critical problem is economics 101. When caps are imposed and market rates are rising, lenders simply adjust their customer eligibility profile to correlate to the interest rates that can be charged.

As a result, the bottom tier of borrowers lose access to credit. Since the passage of the CARD Act in 2009, which regulated many aspects of credit card terms and rates, but did not impose interest rate caps, approximately 14 million subprime cardholders have been pushed out of the credit card market. 

Every time that markets are distorted by non-economic factors, whether it be political or regulatory intervention, they react to that distortion and produce unintended consequences. Sometimes the result is good, sometimes bad and sometimes a disaster.

The savings and loans crisis, for example, was brought to us by the combination of Congress’ enactment of 5.5-percent deposit interest rate caps in 1966, followed by state usury laws of around 8 percent. 

The collision of these two rate controls proved fatal when long-term market interest rates reached upward of 21 percent, and policymakers either didn’t act, took too long to act or took the wrong actions. 

In that regard, the provision in the bill that would allow interest rate caps to be increased after consultation with a host of congressional and regulatory authorities provides little comfort that a similar crisis could be averted. 

A research paper published by the Federal Reserve Bank of Chicago in 1982 stated that the weight of economic evidence supports the conclusion that “[u]sury laws can succeed in holding interest rates below their market levels only at the expense of reducing the supply of credit to borrowers.”  

Another paper presented just this year on the use of interest rate caps in Chile reiterates the direct trade-off between consumer protection and credit availability. The paper found a direct link between the lowering of interest rates through caps and a commensurate reduction of almost 20 percent in credit availability.

Given the country’s track record of having the highest levels of regulation and the greatest frequency of financial crises of nearly any nation in the world in the last two centuries, legislators should be reticent to tinker with the economy until they have fully considered historical precedents and rigorously analyzed the likely array of economic reactions and alternatives. 

As attractive, popular and politically expedient as interest rate caps may seem, such actions ultimately are painful medicine for the folks that really need the help. When it comes to running the largest economy in the world, more care and deliberation would go a long way to making it work better for everyone.

Thomas P. Vartanian is the executive director and professor of law at the Program on Financial Regulation & Technology at the Antonin Scalia Law School at George Mason University.