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Can demand elasticities explain sticky credit card rates?

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  • Joanna Stavins
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    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.

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    File URL: http://www.bostonfed.org/economic/neer/neer1996/neer496c.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1996)
    Issue (Month): Jul ()
    Pages: 43-54

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    Handle: RePEc:fip:fedbne:y:1996:i:jul:p:43-54

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    Related research

    Keywords: Credit cards;

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    Cited by:
    1. Sujit Chakravorti & William R. Emmons, 2001. "Who pays for credit cards?," Occasional Paper; Emerging Payments EPS-2001-1, Federal Reserve Bank of Chicago.
    2. Lucia Dunn & TaeHyung Kim, 1999. "Empirical Investigation of Credit Card Default," Working Papers 99-13, Ohio State University, Department of Economics.
    3. Ayadi, O. Felix, 1997. "Adverse selection, search costs and sticky credit card rates," Financial Services Review, Elsevier, vol. 6(1), pages 53-67.
    4. 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.
    5. 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.

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