US credit card net charge-offs have been rising due to lower lending standards. Is there a similar situation in Australia?
Rising defaults rates are usually indicative of an economy’s health pointing to high levels of unemployment. But, in the US credit card defaults have suddenly started on an upward path despite the official unemployment rate being at a 16-year low of 4.3%. The increasing federal fund rate is also unlikely to provide relief for credit card holders.
Rising credit card losses but below the long-term average
Default rates for credit cards remain below the long-term average, but in the last two quarters, there has been an upturn in credit card charge-offs (uncollectible debts) by the credit card issuers that control around 90% of the market (see Figure 1). According to a report from Moody’s banks must be issuing credit more aggressively due to looser lending standards, as usually there is a strong correlation between rising unemployment and default rates. Figure 2 shows that the ratio between unemployment and charge-offs is weakening.
After the GFC and the resulting recession, US households became more adept at paying down debt and saving money, while credit card issuers faced stricter lending criteria from the Credit CARD Act of 2009. But, now people are missing their payments, despite a stronger economy.
Charge-offs remain at low levels being well below the 20-year historical average rate of 5% (See Figure 3) despite Federal Reserve data showing that borrowers owe US$1 trillion on credit cards surpassing the amount owed in 2008.
Strong growth in credit card lending
Credit card lenders are continuing to aggressively lend, even to sub-prime borrowers who have below average credit scores. Data from credit reporting company TransUnion is showing a pick up in sub-prime borrowers since 2015.
Credit card business is lucrative for lenders as rises in the Fed Fund rate can be passed on quickly leading to increased revenue to offset any increasing losses from lending to borrowers that cannot repay such as subprime. The problem is that when the economy turns downward, there will be rapidly deteriorating asset quality as a result of lending to borrowers with poor credit.
Australian credit card write-offs picked up
Australian consumer lenders (includes credit cards and personal loans) have seen a small pickup in write-offs (credit card debts considered uncollectible and removed from the bank’s balance sheet) despite actual levels being below the ten-year average (See Figure 4), and well below the peak in 2009 of 7%.
Reserve Bank of Australia (RBA) data shows that there is over $50 billion spent on credit cards with over $30 billion attracting interest charges. The total amount on credit cards is higher than pre-2008, although only around 60% of balances accrue interest compared to about 70% in 2008. Higher credit card balances and lower lending standards leading to falling credit quality may lead to the increasing risk of default. The level of write-offs by the major credit card lenders in 2016 is between 1-3% according to data from Banks’ Annual Reports and Pillar 3 Reports, which on average are higher than in 2015.
Unemployment at the time of the most recent credit card default data (December 2016) has been reasonably stable under 6%. Marginally higher write-offs may be contributing to the downward trend of the ratio of unemployment to write-offs in Figure 5, which is following a similar pattern to what has been happening in the US.
Higher credit card limits despite reforms
The introduction of credit card reforms in Australia was partly designed to help consumers pay down their debt more quickly. The reforms also sought to reduce credit card limit growth by preventing unsolicited offers to credit card customers by credit card lenders of increases to credit card limits. Consumers may be paying less interest, but credit card limits are continuing to grow with RBA data showing an increase of over 13% since 2012.
Consumer lending (excluding lending for houses or investor housing loans) has been falling as a part of total lending by the major banks according to ABS data. Although consumer lending may attract higher yields for the lenders than other types of lending, the risks are also higher as it is usually unsecured, so it may be more difficult to recover costs of loan losses. To offset losses interest rates and fees may need to be elevated.
The Senate inquiry into credit cards in 2016 resulted in recommendations such as more thorough checks on borrowers and tighter lending criteria. Stricter lending standards could include ensuring consumers can repay their credit limit “within a reasonable time" as well as initiating a discussion about the suitability of the consumer's current credit card and “where appropriate, provide advice on alternative products".
To prevent Australians defaulting on credit card debt, issuers of credit cards will need tighter lending criteria, in particular with an outlook for a low growth economy, which will continue to dampen wage growth, and increase some borrowers inability to repay debt.