Unintended Consequences of the Credit Card Act

Abstract

This paper asks rst why consumers seek nancing 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 nancing 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 oer credit terms that are inecient relative to a setting with perfect information. This ineciency 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. Specically, 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 for a large set of parameters. 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. Our results are robust to consumers who have limited rationality and underestimate the risk of default and the risk that their creditquality decreases. This paper contributes to the literature by providing a new model of credit cards, and oers predictions of relevance for policy makers.