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Recent Developments in Consumer Credit & Payments

September 29-30, 2005

Abstracts

Economic Research and the Role of the Federal Reserve in Payments

Gary H. Stern, President, Federal Reserve Bank of Minneapolis

The Federal Reserve, as a general matter, decides which payment services to provide and how to provide them based on economic criteria; business rationales play a secondary role. Getting the economics "right" is particularly important today as the Federal Reserve faces potentially significant changes in the scale, product offerings and underlying technology of our retail payments. As a result, economists can make a significant contribution by bringing the developing and related economics of networks and payments to bear on decisions confronting the Federal Reserve.

Accounting for the Rise in Consumer Bankruptcies

Igor Livshits, University of Western Ontario
James MacGee, University of Western Ontario
Michele Tertilt, Stanford University

Personal bankruptcies have increased dramatically: rising from 1.4 per thousand working age population in 1970 to 8.5 in 2002 in the United States. We use one common set-up to evaluate several different explanations put forth in the literature. The framework is a heterogeneous agent life-cycle model with competitive financial intermediaries who can observe households’ earnings process, age and current asset holdings. We find that an increase in uncertainty (income shocks, expense uncertainty) cannot quantitatively account for the rise in bankruptcies. Instead, stories related to a change in the credit market environment are more plausible. In particular, we find that a combination of a decrease in the credit market transactions cost together with a decline in “stigma” does a good job in accounting for the rise in consumer bankruptcy. On the other hand, we argue that the abolition of usury laws and other legal changes have played very little role. We conclude that a theory of stigma is needed.

Credit Registries, Relationship Banking and Loan Repayment

Martin Brown, Swiss National Bank
Christian Zehnder, University of Zurich

This paper examines the impact of a public credit registry on the repayment behavior of borrowers. We implement an experimental credit market in which loan repayment is not third-party enforceable. We compare market outcome with a credit registry to that without a credit registry. This experiment is conducted for two market environments: first a market in which interactions between borrowers and lenders are one-off and, second, a market in which borrowers and lenders can choose to trade repeatedly with each other. In the market with one-off interactions the credit market collapses without a credit registry as lenders rightly fear that borrowers will default. The introduction of a registry in this environment significantly raises repayment rates and the credit volume extended by lenders. In the market where repeat transactions are possible a credit registry is not necessary to sustain high market performance. In such an environment relationship banking enforces repayment even when lenders cannot share information, so that there is little value added of a public credit registry.

How Well Do Consumers Forecast their Future Borrowing?

Sumit Agarwal, Bank of America
Souphala Chomsisengphet, Office of the Comptroller of the Currency
Chunlin Liu, University of Nevada , Reno
Nicholas Souleles, University of Pennsylvania

A number of studies have pointed to various mistakes that consumers make in their consumption-saving decisions. We utilize a unique market experiment conducted by a large U.S. bank to assess how systematic and costly such mistakes can be. The bank offered consumers a choice between two credit card contracts, one with an annual fee but a lower interest rate and one with no annual fee but a higher interest rate. To minimize their total interest costs net of the fee, consumers expecting to borrow a sufficiently large amount should choose the contract with the fee, and vice-versa.

We find that on average consumers chose the contract that ex post minimized their net costs. A substantial fraction of consumers (about 40%) still chose the ex post sub-optimal contract, with some incurring hundreds of dollars of avoidable interest costs. Nonetheless, the probability of choosing the sub-optimal contract declines with the dollar magnitude of the potential error, and consumers with larger errors were more likely to subsequently switch to the optimal contract. Thus most of the errors appear not to have been very costly, with the exception that a small minority of consumers persists in holding substantially sub-optimal contracts without switching.

Observing Unobservables: Identifying Information Asymmetries with a Consumer Credit Field Experiment

Dean Karlan, Yale University
Jonathan Zinman, Dartmouth College

We estimate the prevalence of asymmetric information in a consumer credit market using a field experiment methodology derived from theoretical models. We randomized 58,000 direct mail offers issued by a major South African lender along three dimensions: 1) the initial "offer interest rate" appearing on the direct mail solicitations; 2) a weakly lesser "contract interest rate" revealed to the over 4,000 borrowers who responded to the solicitation and agreed to the initial offer rate; and 3) a dynamic repayment incentive that extends preferential pricing to borrowers who remain in good standing on their first loan taken at the contract rate. These three randomizations, combined with the large sample and complete knowledge of the Lender's information set, permit identification of specific types of private information. Specifically, our setup distinguishes adverse selection from moral hazard effects on repayment, and thereby generates unique empirical evidence on the sources and magnitude of asymmetric information. We find evidence of both adverse selection and moral hazard. These effects are large, both economically and statistically, and help explain the prevalence of rationing even in a market that specializes in financing high-risk borrowers at very high rates.

Predatory Lending in a Rational World

Philip Bond, University of Pennsylvania
David Musto, University of Pennsylvania
Bilge Yilmaz University of Pennsylvania

Regulators express growing concern over "predatory lending," which we take to mean lending that reduces the expected utility of borrowers with bad prospects. We present a rational model of consumer credit in which such lending is possible and we identify the circumstances in which it arises with and without competition. Predatory lending is associated with imperfect competition, highly collateralized loans and poorly informed borrowers. Under most circumstances competition among lenders eliminates predatory lending.

Skewed Pricing in Two-Sided Markets: An IO Approach

Wilko Bolt, De Nederlandsche Bank
Alexander F. Tieman, International Monetary Fund

In two-sided markets, one widely observes skewed pricing strategies, in which the price mark-up is much higher on one side of the market than the other. Using a simple model of two-sided markets, we show that, under constant elasticity of demand, skewed pricing is indeed profit maximizing. The most elastic side of the market is used to generate maximum demand by providing it with platform services at the lowest possible price. Through the positive network externality, full participation of the high-elasticity, low-price side of the market increases market participation of the other side. As this side is less price elastic, the platform is able to extract high prices. Our skewed pricing result also carries over when analyzing the socially optimal prices. Interestingly, this leads to below-marginal cost pricing in the social optimum. We motivate the analysis by looking at the Dutch debit card system.

The Welfare Consequences of ATM Surcharges: Evidence from a Structural Entry Model

Gautam Gowrisankaran, Washington University in St. Louis
John Krainer, Federal Reserve Bank of San Francisco

We estimate a structural model of the market for automatic teller machines (ATMs) in order to evaluate the implications of regulating ATM surcharges on ATM entry and consumer and producer surplus. We estimate the model using data on firm and consumer locations, and identify the parameters of the model by exploiting a source of local quasi–experimental variation, that the state of Iowa banned ATM surcharges during our sample period while the state of Minnesota did not. We develop new econometric methods that allow us to estimate the parameters of equilibrium models without computing equilibria. Monte Carlo evidence shows that the estimator performs well. We find that a ban on ATM surcharges reduces ATM entry by about 12 percent, increases consumer welfare by about 10 percent and lowers producer profits by about 10 percent. Total welfare remains about the same under regimes that permit or prohibit ATM surcharges and is about 17 percent lower than the surplus maximizing level. This paper can help shed light on the theoretically ambiguous implications of free entry on consumer and producer welfare for differentiated products industries in general and ATMs in particular.