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It has long been recognized that interest rates charged on credit card loans are sticky (that is, they remain high even when the cost of funds drops). Although some studies have blamed market power by issuing banks for the persistently high rates,(1) the credit card market is relatively unconcentrated, with hundreds of issuers nationwide. The explanation for the sticky rates is more likely, therefore, to lie on the demand side. Since consumers could minimize their cost of credit by borrowing at the lowest possible rate,(2) one would expect banks to drop their rates to attract customers in the competitive market. Yet issuing banks do not appear to be behaving in this way. Do banks maintain high rates because customers' demand for credit card loans does not respond to changes in the rates they charge (that is, because demand for credit cards is inelastic with respect to the interest rates)? Do consumers indeed borrow at high interest rates because they are irrational, as Ausubel (1991) suggested?

Several theories purport to explain credit card rate stickiness.(3) Although some studies have speculated whether demand for credit cards loans is responsive to interest rates, the only information about demand elasticities comes from consumer survey results.(4) According to evidence presented in Ausubel (1991), however, consumer survey results consistently underestimate how much consumers actually borrow. When the results of consumer surveys are compared to bank data, it turns out that consumers borrow more and repay less than they report. Therefore, evidence about demand elasticities should come from bank data, yet no study has explicitly estimated demand elasticities for credit card loans with respect to the interest rates charged. Using panel data from credit card plans offered by banks, this study estimates consumers' sensitivity to the various attributes of credit card plans: interest rates, annual fees, grace periods, finance charges, and additional enhancements. In the past, regulatory agencies and research economists have focused their analyses of the credit card market almost exclusively on the annual percentage rate of interest (APR). However, customers may be more responsive to other characteristics of the plans. It is worthwhile to find out whether the careful scrutiny the credit card rates have received over the years should be directed at other attributes as well.

Consumers have more credit card plan options today than ever before. Most credit card plans are offered nationwide, and abundant information about them arrives in every day's mail. Each plan is composed of many attributes. Are consumers more likely to borrow at a lower interest rate, pay a lower annual fee, or choose more "bells and whistles"?(5) Consumers may opt for high-APR plans because of their inelastic demand or because those plans compensate them with other features, such as low fees. This article approaches the sticky interest rate puzzle by estimating consumers' demand responsiveness to the various features of credit card plans.

The first section describes the data used in the analysis. Section II addresses the question of whether credit card users are rational. Section III sets up the specification used in this paper, while the following section presents estimation results. Section V examines how a bank's size affects the credit card rates it charges and the demand elasticity it faces. The final section offers a summary and conclusions. The results show that banks face an adverse selection problem: Lowering the APR would attract risky customers or induce existing customers to borrow more than they can handle. As a result, delinquent loans rise at a significantly higher rate than that of loans in general. This induces banks to maintain high interest rates. The adverse selection hypothesis is further supported by the finding that banks' income from credit card fees and interest increases with APR.

I. The Data

This study uses data from a survey on the Terms of Credit Card Plans (TCCP), collected semiannually by the Federal Reserve Board from approximately 200 of the largest issuers of bank credit cards. The survey was conducted each January and July during the 1990-95 period. Smaller banks are not included in the sample. Although they may offer systematically different terms of credit card plans, the sampled banks issue the majority of outstanding credit.(6)

The data include characteristics of each plan, such as annual percentage rates (APR), annual fees, grace periods, minimum finance charges, late payment charges, cash advance fees, and over-the-limit fees, as well as indicators showing whether the plan had additional "enhancements," such as automobile insurance, travel discounts, extended warranty, and the like. The data set was merged with information from bank financial statements filed with the Federal Deposit Insurance Corporation. These Consolidated Reports of Condition and Income (Call Reports) include each bank's deposits and assets, as well as outstanding credit card loans and income from credit card interest and fees. The Call Report data are collected quarterly. Data from March Call Reports were merged with the January TCCP data, and data from September Call Reports were merged with the July TCCP data.(7) Panel data constructed from information on the majority of credit card banks over the period of six years permit analysis of customers' sensitivity to features of credit card plans. Table 1 (below) provides descriptive statistics and definitions of the major variables.

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