Interest Rate Restrictions

The coalition Government have proposed to implement legislation which gives power to the credit regulator – currently the Office of Fair Trading – to define and cap excessive interest rates for both credit and store cards. Interest rate caps have their advocates as well as their opponents.

The argument for them is simple – a rate cap would protect vulnerable consumers who are currently paying higher interest rates and who also have limited opportunity to switch to an alternative lower-priced product. A cap would force some credit companies to charge less.   

But the argument against rate caps is more complex. All the evidence points towards rate caps resulting in less competition between lenders, as well as higher prices and reduced credit availability for many consumers, because lenders are no longer able to price according to risk.    

Setting interest rates

A popular media myth is that interest rates on unsecured consumer credit products are in some way linked to the Bank of England base rate, currently 0.5%. This in turn prompts questions about why interest rates on credit and store cards rose during the recession, just as base rates descended to record lows.

In reality, during a recession, more customers are likely to lose their jobs and in turn struggle to meet their credit repayments; in short, they become riskier and the rates lenders charge reflects this risk. However the increased incidence of default is only one factor. The interest rate will also reflect the rising cost of accessing wholesale funding, higher interchange fees and escalating fraud levels – all of which has been exacerbated in the current economic climate. But the highly competitive nature of the credit and store card market plays a central role in keeping interest rates in check, as customers are swift to change lender if the rate charged no longer presents the best deal.   

Rate caps don’t work

The case for rate caps for credit and store cards has not been made. Rate caps are already used in other countries, including Canada, Germany and parts of Australia and the US, with limited degrees of success. They were also looked at by the (then) Department for Trade and Industry back in 2004, who decided against such an approach.       

The potential for unintended consequences is the main concern. Possibly the most serious of these is the risk of greater financial exclusion. If a lender is constrained in the rate of interest they can charge, they will not lend to anyone whose rate of risk they calculate to be above the cap.

Another potential pitfall of a rate cap is that it prevents lenders from charging a risk-related market rate and so could lead to higher prices for all customers. Interest rates are also prone to converging towards the cap, as it becomes seen as being the “official” interest rate so skewing competition on price between lenders. Finally, caps are often circumvented via increases in other fees and charges. 

Care has to be taken when setting the level of a rate cap. If the cap is too high and interest rates move towards it, those customers who originally would have been offered a lower interest rate could be priced out of the market. If the cap is too low, lending becomes unprofitable leading to lenders exiting the market. This creates the potential for increased financial exclusion and recourse to illegal moneylenders. Of course, this is an extreme case. In reality, it is unlikely that someone denied a credit or store card would seek out the nearest loan shark. But excluding people from credit and store cards needlessly makes their lives more difficult.

The Office of Fair Trading has very recently looked at the practicability of rate caps as part of its review of High-Cost Credit, which reported in June. The OFT found that caps in the high-cost sector would restrict the flow of credit granted to low-income earners and that there were no signs that this gap would be plugged by other lenders on the High Street. The findings also showed that the enforcement of price controls is complex, expensive and difficult to administer. 

We will be working with the Government, and the OFT, to ensure that they are aware of the potential consequences of rate caps and that they avoid irreversible damage to the credit and store card markets.

In January 2011, the European Commission published a study into interest rate restrictions and an accompanying consultation paper which can be downloaded here. The study tests twelve hypotheses about the impact of rate restrictions. It found that rate restrictions (defined widely): 

• tended to reduce access to credit, particularly for low-income borrowers
• reduce the choice of products available to consumers
• increase the overall cost of credit in parts of the market.

The study also found little evidence that credit price restrictions helped to reduce over-indebtedness.    

Eurofinas, the FLA’s umbrella body, organized a workshop for European Commission officials, a summary of which can be viewed here.

On 15 June 2011, the European Commission (EC) published a summary of responses  to its consultation. Feedback was divided between industry, including the FLA, who warned about the detrimental impact of IRR on access to credit which could exacerbate financial exclusion, and consumer representatives, who considered IRR as an important tool against over-indebtedness and loan shark activity. A majority of Member States were opposed to IRR and there was a general consensus that subsidiarity should apply in this area. The EC gave no hint about next steps.