Market Power in Credit Markets

Abstract

We study, theoretically and in a quantitative model, the determinants of lender profits in the cross-section of households. We argue that the empirical pattern of high profit margins for high risk contracts calls for a departure from constant markups or ex-post perfect competition models.

We propose an imperfectly competitive model in which credit pricing is pinned down not only by default probability but also by the household's outside options, giving rise to profit margins distribution consistent with the data. In our economy, we study the effects of limiting lender market power via interest rate caps. We show that the parameterized economy features strong general equilibrium effects by which imposing a limit on a small number of contracts affects the whole interest rate distribution, implying significant welfare gains from the policy.

Keywords: Market Power, Competition, Unsecured Credit, Regulation, Credit Cards, Bankruptcy

JEL Classification: E6, E2