Unintended Consequences of the Credit Card Act

Abstract

This paper asks first why consumers seek financing through credit cards. It then evaluates the impact on consumer welfare of the constraints on increasing interest rates present in the Credit Card Act. We model consumer financing in a setting where consumers do not commit to borrow from a given lender and where information asymmetry between a consumer and a lender arises over time. The existence of ex-post information asymmetry coupled with the lack of commitment leads to adverse selection of consumers which, in turn, prompts lenders to offer credit terms that are inefficient relative to a setting with perfect information. This inefficiency is alleviated if credit contracts have some of the features that we observe in credit cards, and we show that these features arise in the competitive equilibrium credit contract. Specifically, in a competitive equilibrium the issuer charges an up-front fee and commits to an interest rate before a loan is taken; the issuer retains an option to change the interest rate upon new information, and consumers have an option to repay the loan at any time. We also show that restrictions on increasing the interest rate, as in the Credit Card Act, are welfare decreasing. They lead to lower up-front fees, higher credit card interest rates for low credit-quality consumers, and lower credit limit for high credit-quality consumers. This paper contributes to the literature by providing a new model of credit cards, and offers predictions of relevance for policy makers.

Keywords: Consumer Financing, Credit Card Act, Welfare