Determinants of Borrowing Limits on Credit Cards

Abstract

In the credit card market, banks have to decide on the borrowing limits of their potential customers, when the amounts of borrowing to be incurred on these lines are uncertain. This borrowing uncertainty can make the market incomplete and create ex post misallocations. Households who are denied credit could well turn out to have ex post higher repayment probabilities than some credit card holders who borrow large portions of their borrowing limits. This sort of ex post misallocations is due to the adverse selection problem, where consumers who are more likely to borrow on credit cards self-select as credit card users in the first place. However, this borrowing uncertainty makes similar misallocations possible, even among the credit card holders. Our setup also explains how new information on observed borrowing patterns will generate revisions of existing contracts and counter offers (such as balance transfer offers) from competing banks. Using data from the U.S. Survey of Consumer Finances, we propose an empirical solution to the misallocation problem. We show how this dataset can be used by banks to explain some of the systematic variations of their observed customer borrowing patterns and how these borrowing estimates will enable them to better select and retain their customers by devising better contracts. We find support for a positive relationship between the proxies of borrower quality and the approved borrowing limits on credit cards, controlling for the banks' selection of credit card holders and the endogeneity of interest rates. We also find evidence for a positively-sloped credit supply function.

Keywords: Credit, Limit, Uncertainty, Risk, Misallocation

JEL Classification: D4, D8, G2