Carrots Work Better: How Credit Card Companies should seek repayment

Yesterday we examined why and how credit card companies are seeking money back from the customers they once so eagerly loaned to. As discussed, we're seeing "carrots, cajoling, and sticks" the likes of which we haven't yet seen among prime card companies. Today I'll make the case that carrots offer a better approach than sticks. That is, positive incentives are not only the right way to treat customers, but they're the best way for credit card companies to protect their own larger interests.

Sticks alienate like never before. No one is surprised when customers express disappointment at adverse changes in terms. But the financial meltdown and changes in Washington raises the stakes. Financially stressed customers who may have grumbled and paid higher rates before are now feeling pushed to the brink by these tactics. Term changes that might have gone unnoticed by regulators in prior years are now the subject of intense media and governmental scrutiny. And now that tax dollars are being used to fortify all the major credit card lenders, taxpayers and their representatives are demanding a more customer-friendly approach than they would otherwise. As a result,

Sticks cost money. Card company accountants are easily seduced by the money that certain "sticks" might bring in. Their revenue models reflect the arithmetic that if you increase a customer's interest rate, you earn more money on the account--provided that the customer eventually pays in full. However, they do not adequately reflect the increasingly costly externalities that accompany adverse changes in terms. For example, customers enraged by these tactics tie up customer service phone lines and processing time. Legal grievances that card companies could confidently handle with arbitration are now requiring expensive litigation to combat. The negative coverage such tactics generate means having to spend more on public relations, preparation for regulatory hearings, and responses to media inquiries.

Even aside from increased customer service, legal, and public relations expenses, we doubt that card companies adequately account for the growing likelihood that adversely affected customers simply will not pay their bills. Americans are not only pinched like at no time in the past generation: they are also understandably furious with how financial institutions have been comporting themselves. In this environment, the sense that their lenders are not playing fair will be enough to cause countless customers to either put their bills at the bottom of the pile--when little or no money may be left--or simply to not pay. A common theme will be, "I'm so broke now, let them try to come after me."

Now consider how this picture may change if carrots are used instead.

Carrots avoid these pitfalls. No one sues credit card companies who offer incentives for customers who make payments. Regulators don't question bonuses crafted to encourage payment of debt. And when they are thoughtfully constructed, bonuses don't require public relations damage control: on the contrary, they can be packaged as their own PR efforts! "Are you debts overwhelming? Here's how you credit card company can help". Any card company that is seen to take this approach clearly and consistently will begin to be seen as part of the solution, not part of the problem.

Watch for moral hazards and perverse incentives. One potential problem with carrots is that if they aren't crafted thoughtfully, they can backfire. Perhaps the best example here involves partial loan forgiveness in cases of hardship. If word gets out that my credit card company will forgive half its debt when some customers become sixty days late, that company shouldn't be surprised when more customers become sixty days late. American Express's recent $300 gift card initiative offers a more subtle example of potential hazards. Since they offer the carrot only to some cardholders, many wonder why they didn't receive it also. In the internet age, it may not be long before careful observers manage to reverse engineer what Amex is up to, and change their behavior accordingly.

Calibration can help. Since carrots aren't subject to scrutiny or other objections, card companies are at liberty to tweak them at will, narrowing in on what will get the best responses. Maybe a modest $25 statement credit for scheduling automatic payments (and having them honored by the bank) will be enough to keep a number of customers from defaulting--even while reducing the card company's cost of payment processing. A company who needs its capital back could offer five or ten percent credits on any balances paid above the minimum. The possibilities are endless, not just for offering carrots, but for gaging which carrots are most effective.

Bottom line: carrots work better. Provided that they don't unwittingly encourage counterproductive behavior, carrots can work well. They need not be overly costly either, especially considering the savings incurred by avoiding the expensive externalities that come along with sticks. Finally, the good PR and customer goodwill that would accompany carrots could not come at a more helpful time. I'm hoping that as their need for repayment intensifies going forward, card companies remain mindful of the benefits of dangling carrots over swinging sticks.