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Can demand elasticities explain sticky credit card rates?

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  • Joanna Stavins

Abstract

Sticky interest rates on credit card plans have long been a mystery. One possible explanation is that banks maintain high rates because consumers' demand for credit card loans is inelastic. This study tests and rejects that hypothesis. Demand for credit card loans is found to be elastic with respect to interest rates charged, and the amount of delinquent loans is found to increase significantly more than total credit card loans when interest rates drop.> The results show that banks face an adverse selection problem: Lowering the annual percentage rate of interest (APR) would attract risky customers and increase delinquent loans at a significantly higher rate than loans in general. This induces banks to maintain high interest rates. The adverse selection hypothesis is further supported by the finding that banks' income from credit card fees and interest increases with APR. Consumers' demand is also found to be responsive to some of the enhancements added to the terms of credit card plans. Banks may find it optimal to charge high interest rates, while adding enhancements in order to attract customers and raise their income at a low cost.

Suggested Citation

  • Joanna Stavins, 1996. "Can demand elasticities explain sticky credit card rates?," New England Economic Review, Federal Reserve Bank of Boston, issue Jul, pages 43-54.
    • Handle: RePEc:fip:fedbne:y:1996:i:jul:p:43-54
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    Citations

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    Cited by:

    1. Brian Mantel, 2000. "Why don't consumers use electronic banking products? towards a theory of obstacles, incentives, and opportunities," Occasional Paper; Emerging Payments EPS-2000-1, Federal Reserve Bank of Chicago.
    2. Timothy Crack & Helen Roberts, 2015. "Credit card balances and repayment under competing minimum payment regimes," Review of Quantitative Finance and Accounting, Springer, vol. 45(4), pages 785-801, November.
    3. Tal Gross & Raymond Kluender & Feng Liu & Matthew J. Notowidigdo & Jialan Wang, 2021. "The Economic Consequences of Bankruptcy Reform," American Economic Review, American Economic Association, vol. 111(7), pages 2309-2341, July.
    4. Chih-Hsiung Chang & Wu-Hua Chang & Yi-Yu Shih, 2022. "Is Financial Institution Management Effective to Reduce Problems Related to Information Asymmetry in Taiwan?," Bulletin of Applied Economics, Risk Market Journals, vol. 9(2), pages 37-58.
    5. Cash, Alyxandra & Tsai, Hui-Ju, 2018. "Readability of the credit card agreements and financial charges," Finance Research Letters, Elsevier, vol. 24(C), pages 145-150.
    6. Brian Mantel & Timothy McHugh, 2001. "Competition and innovation in the consumer e-payments market? considering the demand, supply, and public policy issues," Occasional Paper; Emerging Payments EPS-2001-4, Federal Reserve Bank of Chicago.
    7. Francisco Gomes & Michael Haliassos & Tarun Ramadorai, 2021. "Household Finance," Journal of Economic Literature, American Economic Association, vol. 59(3), pages 919-1000, September.
    8. Sumit Agarwal & Souphala Chomsisengphet & Neale Mahoney & Strö & Johannes bel, 2015. "Do Banks Pass Through Credit Expansions? The Marginal Profitability of Consumer Lending During the Great Recession," CESifo Working Paper Series 5521, CESifo.
    9. Kathryn L. Combs & Stacey L. Schreft, 1999. "Do consumers really want credit card reform?," Economic Review, Federal Reserve Bank of Kansas City, vol. 84(Q III), pages 31-45.
    10. Sumit Agarwal & Souphala Chomsisengphet & Neale Mahoney & Johannes Stroebel, 2018. "Do Banks Pass through Credit Expansions to Consumers Who want to Borrow?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 133(1), pages 129-190.
    11. Sujit Chakravorti & William R. Emmons, 2001. "Who pays for credit cards?," Occasional Paper; Emerging Payments EPS-2001-1, Federal Reserve Bank of Chicago.
    12. Lucia Dunn & TaeHyung Kim, 1999. "Empirical Investigation of Credit Card Default," Working Papers 99-13, Ohio State University, Department of Economics.
    13. Ayadi, O. Felix, 1997. "Adverse selection, search costs and sticky credit card rates," Financial Services Review, Elsevier, vol. 6(1), pages 53-67.

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    Keywords

    Credit cards;

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