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The Economics of Credit Cards by Todd J. Zywicki* Table of Contents

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The Economics of Credit Cards by Todd J. Zywicki* Table of Contents The Economics of Credit Cards by Todd J. Zywicki* Table of Contents I. Introduction.......................................................................................................................2 II. Modeling Credit Card Use by Consumers.........................................................................6 A. Credit Cards as a Transactional Medium ......................................................................6 1. Cash......................................................................................................................8 2. Checks................................................................................................................10 3. Credit Cards........................................................................................................13 B. Credit Cards as Borrowing Medium ...........................................................................23 C. Understanding Consumer Demand for Credit Card Borrowing....................................29 1. Do Consumers Shop for Lower-Interest Rates? ...................................................31 a. Interest Rates Are Irrelevant for Convenience Users ............................................32 b. Larger Revolvers Shop for Lower Interest Rates .................................................36 2. Rearranging Intertemporal Consumption Streams..................................................43 3. Conclusion...........................................................................................................44 III. Has Competition Failed in the Credit Card Industry?......................................................44 A. Are Credit Card Interest Rates “Sticky”?....................................................................46 B. Are Credit Card Interest Rates “High”? ......................................................................58 1. Costs of Credit Card Operations..........................................................................59 2. Higher Risks of Credit Card Operations ...............................................................63 a. Moral Hazard and Post-Contractual Opportunism...............................................63 b. Other Factors Increasing Credit Card Risk..........................................................66 C. Consumer Irrationality................................................................................................69 IV. Credit Card Profits .......................................................................................................70 A. Market Structure........................................................................................................71 1. The Credit Card Market Is Structurally Competitive .............................................71 2. Entry Has Dissipated Any Profits..........................................................................73 B. Accounting Returns Are Not Economic Profits............................................................75 1. Ex Ante v. Ex Post Profits and the Need for Risk Adjustment ...............................77 2. Traditional Measures Focus Only on Successful and Profitable Issuers..................79 3. Interbank Premia on Credit Card Sales Have Dissipated.......................................81 C. The Credit Card Market Is Dynamically Competitive ..................................................82 D. Are Consumer Search and Switch Costs High?...........................................................83 1. Information Costs ................................................................................................85 2. Fear of Rejection.................................................................................................89 * Assistant Professor of Law, George Mason University School of Law. J.D. University of Virginia, M.A. Economics, Clemson University. I would like to thank the Honorable Samuel L. Bufford for helpful comments at the Chapman Bankruptcy Law Symposium. I would like to thank the Law and Economics Center at George Mason University School of Law and the George Mason University School of Law for financial support for this project. 3. Billing of Annual Fees on an Annual Basis.............................................................90 4. Advantages of Long-Term Card Ownership .........................................................91 5. Time Delays in Receiving a New Card..................................................................91 6. Conclusion: Search and Switch Costs in the Credit Card Market Are Low and Falling..........................................................................................................................92 E. Post-Mortem on the Failure of Competition in the Credit Card Industry and Issuer Profitability......................................................................................................................93 V. Usury Regulations and the Misunderstood Role of Marquette.........................................95 A. Was Marquette Irrelevant?........................................................................................96 B. A Short History of Usury Regulations..........................................................................97 C. The Problems of the pre-Marquette Regime.............................................................102 D. Indirect Costs of Usury Regulations ..........................................................................108 E. Empirical Analysis of Usury Regulations and the Case for Marquette.........................114 F. Benefits of Marquette and the Deregulation of Credit Card Interest Rates .................121 VI. Some Tentative Bankruptcy Implications of the Economics of Credit Cards..................123 VII. Conclusion................................................................................................................129 I. Introduction The skyrocketing bankruptcy filing rates of recent years are well known. Last year over 1.3 million families filed for bankruptcy. Amazingly, that figure actually represented a slight drop from the previous year. Anxious to deflect blame from an overly generous bankruptcy system or a decline in the shame and stigma traditionally associated with filing bankruptcy, opponents of bankruptcy reform have fingered promiscuous lending practices by credit card issuers as the primary culprit in the bankruptcy boom.1 In particular, it is charged that, spurred on by high profits, credit card issuers have extended increasing amounts of credit to ever-riskier borrowers. If this is so, then the credit card companies have no one to blame but themselves when these borrowers default on their obligations, file for bankruptcy, and impose losses on lenders. For similar reasons, some bankruptcy judges have frowned upon dischargeability 1 See Edith H. Jones & Todd J. Zywicki, It’s Time for Means-Testing, 1999 BYU L. REV. 177, 224-28 (1999) [hereinafter Jones & Zywicki]. 2 objections by credit card issuers. Moreover, it is said to be the height of hypocrisy for these same credit card issuers to then turn around and demand tighter bankruptcy laws to bail them out of this problem of their own making. Finally, it is argued that because these losses simply come out of the “profits” of credit card issuers, bankruptcy simply results in a wealth transfer from lenders to borrowers and no resultant efficiency loss for other consumers. But this theory rests on a substantial number of questionable assumptions about nature of the credit card market and about the nature of rational credit card use by consumers. It assumes a persistent failure of competition in the credit card market, despite the existence of thousands of firms, low barriers to entry, and high levels of dynamic competition during the very period that high profits supposedly persisted. It further assumes a remarkable degree of consumer irrationality, requiring consumers to underestimate their credit card bills – and only their credit card bills and none of their other financial obligations – month after month and year after year. It requires assuming that consumers never become more intelligent about their options, despite billions of dollars spent by credit card companies to inform consumers of the different product options that are available to them. It requires a belief that the sole indicium of competition in this market is the responsiveness of credit card interest rates despite the fact that only a minority of credit card users revolve balances from month to month. The thesis requires assuming that credit card users are homogenously concerned only about interest rates and not about any other term of the credit card contract, whether benefits, grace periods, or annual fees. In short, for the argument to be plausible, it requires a series of heroic assumptions about persistent profits in a market with low barriers to entry, a failure of competition in a market with all structural indicia of competitiveness, a peculiar and extraordinarily narrow definition of the 3 indicia for measuring competition, and a failure of consumer rationality in a situation where there are strong incentives for consumers to act rationally and to learn over time. Alternatively, it could be argued that the credit card market is competitive and that consumers use credit cards rationally. As this article will show, both credit card issuers and consumers appear to act in a manner consistent with the predictions of economic theory. It is not necessary to rely on implausible assumptions about consumer
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