Randall J. Pozdena

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 91-42, November 29,1991
Solving the Mystery of
High Credit Card Raies
The behavior of credit card interest rates has
befuddled many observers. The rates seem high,
relative to other interest rates, currently averaging
about 12 percentage points above the Treasury
bill rate. In addition, whereas market interest
rates have declined significantly since the early
1980s, credit card rates have not moved down
significantly. Indeed, the spread between the
Treasury bill rate and credit card rates has dou-
bled in that time.
The credit card industry has not offered a good
explanation of the behavior of credit card rates.
in light of the high level of credit card rates,
therefore, about half the states have imposed usu-
ry limits on credit card rates. While credit card
issuers have been able to avoid these restrictions
in many cases by moving their activities to other
states, other policy makers recently have pro-
posed national rate caps. It is important to know
whether such usury laws are justified.
The purpose of this Weekly Letter is to present a
simple view of credit card rate-setting that pro-
duces the high and insensitive rate structure
observed. The model is used to reproduce the
actual historical performance of credit card rates.
The conclusion is that high and invariant credit
card rates are not necessarily evidence of a fail-
ure of competition in the credit card market.
This calls into question the advisability of usury
restrictions.
The credit card market
Credit cards are both payment and credit de-
vices. Cardholders can use them in lieu of cash
for a variety of retail transactions. At any given
time, a bit fewer than half of all cardholders also
use them to access a revolving credit line of a
preset amount. The use of credit cards as a pay-
ments device is growing at the rate of about 10
percent per year. The amount of credit card debt
outstanding is growing at about a 6 percent an-
nual rate and represents about 30 percent of all
consumer installment credit.
Providers of "interchange" services (such as
MasterCard and Visa) transmit payment informa-
tion between the cardholder's and the merchant's
banks. However, the issuing institution sets the
card's terms, including the interest rate, the grace
period, annual fees, penalties, and most other
card features. While there are relatively few sup-
pliers of interchange services, according to the
Nilson Report there are at least 5,000 credit card
issuers in the United States (excluding private
label variations of these cards). In addition, entry
into the business is relatively easy, with individ-
ual retailers and other commercial entities of
even modest size offering credit card plans.
Resolving a conundrum
The existence of this many suppliers normally
would be expected to lead to aggressive price
competition. Yet, credit card rates appear to be
very sticky, responding sluggishly, if at all, to
trends and fluctuations in other market interest
rates. The volatility of credit card rates is less than
one-fifth that ofTreasury Bill rates, forexample,
and the correlation between the two interest rates
over the past 10 years has been less than 0.1.
In addition, as pointed out by Ausubel (1991) and
the Board ofGovernors (1991), the rate of return
to banks on credit card assets appears to be high
relative to the return observed for other bank
assets. Yet actual loss (charge-off) rates do not
appear to be very high, averaging below 3 per-
cent for most of the past decade-seemingly too
little to justify a 12 percent premium over riskless
rates.
All of this evidence is seen as being consistent
with abnormally high profits in credit card lend-
ing, in sharp contrast to what would be expected
given the structure of the industry.
To resolve this conundrum, it is necessary to
focus on the nature of the debt created by using
the revolving credit feature of a credit card. In
particular, credit card debt is unsecured debt;FRBSF
when a customer uses a credit card in a pur-
chase and does not payoff the balance within
the grace period, the issuing bank acquires an
unsecured loan. That is, neither the merchandise
purchased, nor any other asset of the cardholder,
may be repossessed easily by the lender to en-
sure payment.
The obvious reason for this feature is that for
small transactions, the additional contractual
steps involved in establishing title as part of the
loan agreement would be costly. (Such steps do
make sense, on the other hand, for larger denom-
ination installment credit, such as auto loans or
home equity lines.)
The only avenue open to the lender to obtain
repayment from delinquent cardholders is to
proceed in court against the general assets or
income of the cardholder and to report the delin-
quency to credit rating agencies. In the former
case, the transactions costs conceivably could
be large relative to outstanding balances, which
average only about $1,200 per card in 1990 (us-
ing data from the market for credit card-backed
securities). The threat of impaired credit ratings
serves to discipline the user against excessive
use of the card, but does not actually assist in
recovery of outstanding balances.
Modeling credit card debt
Finance theory provides a way of pricing risky
debt using options pricing theory, by recognizing
that the default potential of a loan essentially im-
plies the existence of a financial option. Using
such models, it can be shown that the value (to
the lender) of such a loan depends on more than
just the market interest rate; in particular, the
loan value declines with increases in the riski-
ness of the cardholder's net worth (which pro-
vide the ultimate security ofthe loan) and with
decreases in collateralization.
If the issuing bank can predict the risk accurately,
of course, it can charge a higher initial interest
rate on the credit to compensate for the addition-
al risk. However, even ifthe bank knows the risk
beforehand, its ability to control the riskiness of
the borrower, once the borrower has the credit, is
limited. Indeed, once the borro\'ver has the funds
at an agreed upon price, he has a strong incen-
tive to use it under conditions that are most fa-
vorable to him-namely, when his net worth is
impaired. The issuing bank has limited ability to
identify when these conditions prevail and to
exercise control over its exposure.
Banks can (and do) impose limits on credit card
credit as a means of controlling exposure. In
addition, credit card companies try to identify
consumer segments that pose lower risks of de-
fault (and these selective issuers charge lower
rates). But within any consumer segment, the
lender can never be certain how leveraged the
borrower has become because of other obliga-
tions, and because of the lack of collateraliza-
tion, must assume "worst case" exposure within
each segment.
Implications
The primary, practical solutions to this so-called
"moral hazard of lending" dilemma are (1) to
collateralize the loan (a possibility likely fore-
closed because of the title cost considerations
expressed above), or (2) to price the loan assum-
ing maximum risk exposure. That is, credit card
debt interest rates must be set very high in order
to compensate the issuer for the fact that users
will adjust their risk in response to the price of
the credit.
Indeed, it there were no way to limit the moral
hazard problem, no rate would be high enough.
(As a practical matter, of course, the reputational
costs associated with a bad credit rating help cap
extreme behavior of borrowers.) The result is that
under conditions of poor collateralization, lend-
ers must charge considerably higher credit card
rates than when lending is secured, even to
"creditworthy" segments. (In addition, it can be
shown theoretically that the rate on a poorly col-
lateralized loan is insensitive to variations in
riskless rates.)
The resultant use of high rates implies that credit
card debt will be "overpriced" for households
that pose low risks of default. These households
will tend not to use the revolving credit features
of their cards, but rather to use them mainly as
transactions devices. (In practice, slightly more
than half of all cardholders use the cards without
running credit balances.) They will be primarily
sensitive to annual fees and the grace period, an
implication consistent with observations of credit
card marketers cited by Ausubel.
"Riskier" households, on the other hand, will
self-select into using the credit feature of their
cards because, for them, the rate premium is
attractive given the costs to them of alternative
credit. Although the charge-off rate for these
borrowers will be accordingly high, the average
across all outstanding balances is reduced by
those who choose to pay at the end of the graceperiod, partly explaining the low, actual charge-
off rates.
Simulating credit card pricing
The options pricing model described above can
be stated mathematically, and its parameters esti-
mated by varying them until they best fit the his-
torical experi~nce of credit card rates. Through
such an exercise, we can determine (1) if it is
possible for the model to match actual credit
card pricing and (2) ifthe parameters are consis-
tent with the assumptions of the nature of credit
card debt. In particular, we can see whether it is
priced assuming a low level of collateralization
and high marginal risk.
The author performed this exercise, using a simple
Black-Scholes type representation of collateral-
ized debt. Actual short-term interest rates were
used, with all other parameters ofthe model
selected using an optimization technique to find
the best fit of the modeled rates to actual credit
card rates. The results, presented in the Chart,
show that it was easy to fit the options-based
model to the actual data, even if it is assumed
that the risk exposure of the lender has not varied
over this time period. (In addition, there is no
attempt to control for the removal of interstate
usury controls in 1982.)
Actual and Simulated Credit Card Rates Percent
20
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C d R Card Rate,
ar ate, Simulated 16
Actual 14
12
10
8
6
4
2
o
1973 1976 1979 1982 1985 1988 1991
More importantly, however, the parameters of the
underlying model are consistent with the repre-
sentation of credit card debt as costly-to-service,
unsecured credit extended to relatively high-risk
borrowers. Specifically, the loan seems to be
priced as if the lender perceived the debt as
poorly collateralized or costly to service, and the
variance of the borrower's net worth as high. (As
a point of reference, the implied variance is simi-
lar to the variance in the S&P 500 returns.) As a
check on the internal consistency of the simula-
tion exercise, the term of the credit card debt was
also estimat~d, rather than assumed, as a part of
the empirical exercise. The implied term of the
credit card debt in the model is about four years,
in the range of the terms implied in secondary
market sales of credit card debt.
Conclusion
In Ausubel's very thorough study of the credit
card market, he concludes that cardholders were
"irrational;' acquiring the cards with no inten-
tion of ever using them, but ending up incurring
large credit card balances and debt service costs.
The implication of the analysis here is that no
such irrationality need be invoked. Rather, the
high, and insensitive, credit card rates are con-
sistent with the pricing of risky credits in an
atmosphere of moral hazard and costly collat-
eralization or service. The fact that credit card
issuers that do offer lower rates do so only to
more carefully selected consumer segments also
is consistent with the risk management model
employed here.
This alone, of course, does not prove that the
credit card market is as competitive as it should
be. However, the current performance of credit
card rates is completely consistentwiththe
model used in this Letter. This suggests that at-
tempts to reduce credit card rates through usury
legislation will have the effect of exposing banks
to increased risk, and reducing the availability of
consumer credit. This is a curious policy direc-
tion in an economy already plagued by weak
financial institutions and sluggish credit growth.
Randall J. Pozdena
Vice President
References
Ausubel, L. 1991. "The Failure of Competition in the
Credit Card Market:' American Economic Review
(March) pp. 50-81.
Board of Governors of the Federal Reserve System.
1991. "Profitability of Credit Card Plans: Second
Annual Report to Congress:'
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Index to Recent Issues of fRBSf Weekly Letter
DATE NUMBER TITLE AUTHOR
5117 (91-20) Recession and the West Cromwell
5/24 (91-21 ) Financial Constraints and Bank Credit Furlong
5/31 (91-22) Ending Inflation Judd/Motley
6/7 (91-23) Using Consumption to Forecast Income Trehan
6/14 91-24 Free Trade with Mexico? Moreno
7/5 91-25 Is the Prime Rate Too High? Furlong
7119 91-26 Consumer Confidence and the Outlook for Consumer Spending Throop
7/26 91-27 Real Estate Loan Problems in the West Zimmerman
8116 91-28 Aerospace Downturn Sherwood-Call
8/30 91-29 Public Preferences and Inflation Walsh
9/6 91-30 Bank Branching and Portfolio Diversification Laderman/Schmidt!
Zimmerman
9/13 91-31 The GulfWar and the u.s, Economy Throop
9/20 91-32 The Negative Effects of Lender Liability Hermalin
9/27 91-33 M2 and the Business Cycle Furlong/Judd
10/4 91-34 International Output Comparisons Glick
10111 91-35 Is Banking Really Prone to Panics? Pozdena
10118 91-36 Deposit Insurance: Recapitalize or Reform? Levonian
10/25 91"37 Earnings Plummet at Western Banks Zimmerman
1111 91-38 Bank Stock Risk and Return Neuberger
11 /8 91-39 The False Hope ofthe Narrow Bank Pozdena
11/15 91-40 The Regional Concentration of Recessions Cromwell
11/22 91-41 Real Wages in the 1980s Trehan
The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.

Board of Governors of the Federal Reserve System.

The Failure of Competition in the Credit Card Market:'

Solving the mystery of high credit card rates

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Solving the mystery of high credit card rates

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