Credit Card Reform – What does the National Consumer Credit Banking Reform mean for you?

At the height of election campaigns in 2010, the Australian government under Prime Minister Julia Gillard came out with a list of credit reforms it promised to impose on the banking industry.

Its main target was consumer lending—credit cards, personal loans, mortgages—where the rules were believed to be too lax and the rates too high, leading Australians into an eventual debt crisis. Previous reforms had been put in place in 2009, but with debt levels going nowhere, it was clear that more concrete action was needed.

Last month, the "laundry list" was made public, and the government announced they would come into effect by mid-2012. The Fairer, Simpler Banking regulations include eight separate measures that would change the way lenders structured, marketed, and sold credit products to consumers. They would also give people more choice as to how much they borrowed, push for transparency in lending rules, and put a cap on interest rates for consumer debt.

The measures outlined in the Credit Reforms in Australia include:

1. Eliminating negative payment hierarchy

Negative payment hierarchy is a common practice in which banks pay off low-interest debts before high-interest ones. This is commonly used in introductory offers and balance transfer cards, where interest is low or zero in the first few months. This leaves high-interest debt to accumulate during the promotion period, leaving borrowers with more debt than savings at the end of the day. The reforms will ban this practice, requiring banks to allocate payments to higher-interest debts first. National Australia Bank was among the first to do this when it abandoned the practice in September 2010.

2. Standardizing interest

Credit card providers will be required to calculate interest rates according to industry-approved rules, and make the process available to customers so they can better compare them with other credit cards. This will limit the snap decisions that often trap borrowers, such as a low interest rate that turns out to be variable, or a balance transfer deal with hidden restrictions. If they can see where the numbers come from, they can better decide what’s worth their money.

3. Keeping borrowers informed

Under the new law, credit card application forms will include a summary of the card’s main features. According to the Fairer, Simpler Banking fact sheet, this will draw borrowers’ attention to terms and conditions they would otherwise overlook, and notice only when unexplained charges show up on their statements.

4. Making the costs clear

Customers must also be clearly informed of the costs of credit card use, particularly that of making only minimum repayments. Although paying by credit card will always cost more than paying by cash or debit, a big difference exists between those who pay in full and those who pay only the minimum every month, making only the standard 2% minimum repayment could drag a small debt on for decades. By making customers aware of this, banks can reduce their level of bad debts and borrowers can avoid credit traps.

5. Prohibiting over-the-limit fees

Credit card users can no longer be charged over-the-limit fees when they exceed their credit limits, unless they allow their issuer to do so in writing. Normally a transaction simply won’t go through if the credit limit has been reached, but some banks have removed this barrier. Instead, they let the credit pile up and simply charge an excessive fee at the end of the billing cycle. The new law will make this optional.

6. Banning unsolicited credit limit increase offers

Sweeney Research, a Melbourne consumer research firm, found that 84% of credit card holders in Victoria have been offered an increased credit limit by their banks. A typical customer can assume that since the bank has found them eligible for an increase, they must be able to afford it—which is seldom the case. Fairer, Simpler Banking will allow banks to offer you a higher credit limit only if you’ve checked the option in your application.

7. Allowing you to choose your credit limit

Under previous credit card rules, banks determined credit limits according to information provided by the applicant and obtained from credit bureaus, according to the Australian Securities and Investments Commission. Widely used risk models may allow for a higher or lower credit limit than what the applicant can really afford. The new rules will allow the applicants themselves to nominate a credit limit based on how much the need or are able to afford, which banks can then evaluate.

8. Requiring proper assessment

Banks are presently required to determine whether a customer can make the minimum monthly repayments, which can be as low as 2%. As we’ve said above, this can quickly become costly. The proposed rules will require them instead to assess a borrower’s capacity to repay the debt "within a reasonable period."

What do the credit reforms mean for banks and borrowers?

Borrowers are naturally the main beneficiaries of the new agenda. It keeps them from over-borrowing by allowing them to make smarter choices and limiting the influence of banks on their decisions. But it also gives them more responsibility: they now have more incentive to read credit terms more thoroughly and shop around for the most competitive deals. Certain policies will save them money in a passive way; for example, NAB’s decision to eliminate negative payment hierarchy is expected to save customers some $170 per year.

For banks, the effects are more complicated. With the exception of NAB, most major players and industry groups are opposing the reforms. Citigroup believes they limit banks’ ability to interfere when borrowers choose a credit limit they cannot manage. Westpac thought banks weren’t given enough time to respond to the bill (two working days) after being given the draft. The Australian Bankers’ Association points out that banning credit limit increase offers will have little effect, as defaults are linked to unemployment rather than bank marketing.

There may also be larger-scale effects. Jack Stephenson, director of the New York-based business consulting firm McKinsey & Co., thinks that the reforms will turn off specialist card providers that have begun to grow in the States and are expected to enter foreign markets soon.

Credit Reforms elsewhere in the World

The financial crisis was a wake-up call to many developed countries, where access to consumer credit has boomed over the past decade. In the U.S., for example, President Barack Obama introduced similar legislations with the Credit Card Act of 2009, helping to keep borrowers from falling into credit traps. The reforms imposed rules on interest rate assignments, over-the-limit fees and transactions, and protection for young cardholders, among others. The downside is that many banks responded by charging higher annual fees, lowering grace periods, and raising fees wherever they can, such as cash advances and late payments. Australian banks may end up doing the same to recoup their losses.

Canada’s version of the reform was met with more resistance. Finance Minister Jim Flaherty’s measures include an interest-free grace period on new purchases for cardholders who pay their debt in full. Other parties complained that the move would be costly to implement—banks alone would lose tens of millions—and may raise merchant fees which would inevitably be passed on to consumers.

Australia’s credit crisis

Australia has one of the biggest consumer debt levels in the world, approaching $50 billion according to recent figures. While that comes to only a little over $3,300 per cardholder, combined with lax measures (such as low minimum repayments) it can take decades for an individual to pay off. Even more alarming is how it keeps going up: the tab was $40 billion in 2007, $43 billion in 2008, and $45 billion in 2009. And just in the first half of 2011, it grew another $2 billion to reach current levels. Compare this to five and ten years ago, when we owed $33 billion and $15 billion respectively.

Low-income families are naturally the hardest-hit by the debt crisis. Interestingly, they are also banks’ favourite targets. A report from Consumer Affairs Victoria revealed that low-income earners are often the most likely to take banks up on unsolicited credit card offers, being unable to access other means of financing. The credit card reforms will prohibit banks from specifically targeting low-income families, and making unsolicited offers only to customers who reasonably fit the product’s criteria. Less disadvantaged consumers aren’t immune to bank schemes—a Choice survey revealed that in most loyalty programs, consumers had to spend more than $2,000 to get any substantial rewards.

There are other things to blame for Australia’s debt crisis; in fact, it can be argued that banks are simply preying on an underlying situation. For example, the problem of financial exclusion is widespread—many people cannot access the most basic of financial products such as savings accounts, let alone personal loans. According to a paper published in the Macquarie Law Journal, the financially excluded will turn to credit cards when times are tight, putting themselves in an even bigger fix than they have to. The rising cost of education has also contributed to consumer debt, as more and more students are forced to finance their living expenses with credit cards.

What will the credit reforms do?

Some have argued that since bank policies aren’t solely responsible for Australia’s debt problems, changing them isn’t the ultimate solution. But there’s little doubt that reforms are a step in the right direction. For instance, they will force banks to better match their products to their customers, allow consumers to make more educated choices, and make credit more affordable and accessible to those who need it most.

Moreover, they will make consumer credit less expensive. Of the $49.3 billion Australians owe on credit cards, about $35 billion is subject to interest rates, which average around 20%. Since the reforms will control to a certain degree how much interest a bank can charge, this average will significantly go down. And with changes such as the abolishment of negative payment hierarchy, debts that do accrue interest will do so at a much more comfortable rate.

As expected, banks were among the first to criticise the new policies. It’s not that they cannot afford it. The Big Four banks, which issue about two-thirds of all credit cards in Australia, reportedly earn about $470 million in over-the-limit fees alone, which pales in comparison to the more than $11 billion they earned just in the first half of 2011. The same report also showed that National Australia Bank, the first of the four to take on the reforms, saw its profits rise 22% in the said period, the first time it has aced the list in terms of profit increase.

This isn’t to say the reforms do not inconvenience them in any way. The banks’ main arguments, which have been mentioned above, are valid and deserve to be heard. For one thing, they could have been given more than two days to go over the changes and decide whether or not to implement them. At the very least, they probably need more time to shift roles from provider to counselor. But the question at the end of the day is whether these inconveniences are a fair price to pay for financial breathing space. With the world’s highest household debt-to-income ratio, there’s no doubt that Australia needs it.

Managing consumer choice

The credit card reforms clearly focus on giving customers more choice when it comes to financial products. But Citigroup may have had a point when it suggested banks should retain some authority on the matter. Let’s take the freedom to choose one’s credit limit, for example. Banks are put at fault for giving out "pre-approved" credit limit increases to customers who clearly cannot afford them, but the reforms imply that consumers can make much better choices by themselves.

One thing banks could do better—and it doesn’t take a credit reform to do it—is to simply be more generous with rate cuts. When banks cut rates on credit products, the benefits take a long time to trickle down to credit cards, where they are needed the most. According to Peter Arnold, a financial analyst, they should be doing the opposite. Banks should voluntarily cut credit card interest rates on people who obviously need them, such as those with excessive debt loads. Instead, they let these people borrow even more (usually by allowing them to go over limit) and put more interest in their pockets. Others sell the debt to debt collectors, who can hound the unsuspecting borrower for full payment and even threaten to seize their assets.

On the whole, credit card reforms will fix some of Australian consumers’ most urgent problems. For one, since the new rules will apply to new and existing credit cards, it will stem the growth of interest charges, the costliest part of credit card ownership, across the board. But they don’t quite get to the root of it, which is people’s ability to make smart choices. Financial literacy in Australia leaves a lot to be desired. The ANZ Financial Literacy Report in 2008 showed that while 65% of respondents used credit cards, only a handful took steps to reduce costs—12% made it a habit to pay off their balance in full, 9% met monthly minimum payments, and 6% tried to stay within their credit limits.

The rest of the pack can only be helped so much by the reforms. They should be implemented, but the work doesn’t stop there. If banks and governments worked together to create a more financially savvy public, the rest could follow. Keeping spending in check will mean more savings and investments, which can have positive effects for the economy. Choosing the right financial products will naturally drive bad ones out of the market.

With stronger competition, banks will be forced to roll out better credit options, that are focused on providing consumers flexibility and convenience. Australia’s credit reforms are promising, and with a bit of refinement, it can help improve the banking system in Australia to be better off for Australian credit card users.

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