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Costly Contracts and Consumer Credit

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(Updated February, 2014) Financial innovations are a common explanation for the rise in credit card debt and bankruptcies. To evaluate this story, we develop a simple model that incorporates two key frictions: asymmetric information about borrowers’ risk of default and a fixed cost of developing each contract lenders offer. Innovations that ameliorate asymmetric information or reduce this fixed cost have large extensive margin effects via the entry of new lending contracts targeted at riskier borrowers. This results in more defaults and borrowing, and increased dispersion of interest rates. Using the Survey of Consumer Finances and Federal Reserve Board interest rate data, we find evidence supporting these predictions. Specifically, the dispersion of credit card interest rates nearly tripled while the “new” cardholders of the late 1980s and 1990s had riskier observable characteristics than existing cardholders. Our calculation suggest these new cardholders accounted for over 25% of the rise in bank credit card debt and delinquencies between 1989 and 1998.

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Bibliographic Info

Paper provided by University of Western Ontario, Economic Policy Research Institute in its series University of Western Ontario, Economic Policy Research Institute Working Papers with number 20111.

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Date of creation: 2011
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Handle: RePEc:uwo:epuwoc:20111

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Postal: Economic Policy Research Institute, Social Science Centre, University of Western Ontario, London, Ontario, Canada N6A 5C2
Phone: 519-661-2111 Ext.85244
Web page: http://economics.uwo.ca/research/research_papers/epri_workingpapers.html

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Keywords: credit cards; endogenous financial contracts; bankruptcy;

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References

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  1. Jaromir B. Nosal & Lukasz A. Drozd, 2008. "Competing for Customers: A Search Model of the Market for Unsecured Credit," 2008 Meeting Papers 274, Society for Economic Dynamics.
  2. Allen N. Berger & W. Scott Frame & Nathan H. Miller, 2002. "Credit scoring and the availability, price, and risk of small business credit," Working Paper 2002-6, Federal Reserve Bank of Atlanta.
  3. Alberto Bisin & Piero Gottardi, 2005. "Efficient Competitive Equilibria with Adverse Selection," CESifo Working Paper Series 1504, CESifo Group Munich.
  4. William Adams & Liran Einav & Jonathan Levin, 2009. "Liquidity Constraints and Imperfect Information in Subprime Lending," American Economic Review, American Economic Association, vol. 99(1), pages 49-84, March.
  5. Satyajit Chatterjee & Dean Corbae & Jose-Victor Rios-Rull, 2006. "Finite-Life, Private-Information Theory of Unsecured Debt," 2006 Meeting Papers 781, Society for Economic Dynamics.
  6. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
  7. Kartik Athreya & Xuan S. Tam & Eric R. Young, 2012. "A Quantitative Theory of Information and Unsecured Credit," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 153-83, July.
  8. Jaffee, Dwight M & Russell, Thomas, 1984. "Imperfect Information, Uncertainty, and Credit Rationing: A Reply," The Quarterly Journal of Economics, MIT Press, vol. 99(4), pages 869-72, November.
  9. Juan M. Sánchez, 2010. "The IT revolution and the unsecured credit market," Working Papers 2010-022, Federal Reserve Bank of St. Louis.
  10. Robert Shimer & Randall Wright & Veronica Guerrieri, 2009. "Adverse Selection in Competitive Search Equilibrium," 2009 Meeting Papers 139, Society for Economic Dynamics.
  11. N. Narajabad, Borghan, 2010. "Information Technology and the Rise of Household Bankruptcy," MPRA Paper 21058, University Library of Munich, Germany.
  12. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
  13. Kartik Athreya, 2001. "The growth of unsecured credit : are we better off?," Economic Quarterly, Federal Reserve Bank of Richmond, issue Sum, pages 11-33.
  14. Margaret J. Miller (ed.), 2003. "Credit Reporting Systems and the International Economy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262134225, January.
  15. Arthur B. Kennickell & Martha Starr-McCluer & Brian J. Surette, 2000. "Recent changes in U. S. family finances: results from the 1998 Survey of Consumer Finances," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-29.
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Cited by:
  1. N. Narajabad, Borghan, 2010. "Information Technology and the Rise of Household Bankruptcy," MPRA Paper 21058, University Library of Munich, Germany.
  2. Arellano, Cristina & Bai, Yan & Zhang, Jing, 2012. "Firm dynamics and financial development," Journal of Monetary Economics, Elsevier, vol. 59(6), pages 533-549.
  3. Athreya, Kartik & Tam, Xuan S. & Young, Eric R., 2009. "Unsecured credit markets are not insurance markets," Journal of Monetary Economics, Elsevier, vol. 56(1), pages 83-103, January.
  4. Lukasz A. Drozd & Ricardo Serrano-Padial, 2013. "Modeling the credit card revolution: the role of debt collection and informal bankruptcy," Working Papers 13-12, Federal Reserve Bank of Philadelphia.
  5. Daniel R. Sanches, 2010. "A dynamic model of unsecured credit," Working Papers 11-2, Federal Reserve Bank of Philadelphia.
  6. Jason Allen & H. Evren Damar & David Martinez-Miera, 2012. "Consumer Bankruptcy and Information," Working Papers 12-18, Bank of Canada.
  7. Kartik B. Athreya & Xuan S. Tam & Eric R. Young, 2009. "Are harsh penalties for default really better?," Working Paper 09-11, Federal Reserve Bank of Richmond.
  8. Guiso, Luigi & Sodini, Paolo, 2012. "Household Finance: An Emerging Field," CEPR Discussion Papers 8934, C.E.P.R. Discussion Papers.
  9. Borghan Nezami Narajabad, 2012. "Information Technology and the Rise of Household Bankruptcy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(4), pages 526-550, October.

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