THE AMERICAN ECONOMIC REVIEW MARCH 1991 TABLE 4-LOAN LOSSES ON CREDIT CARDS OF TEN SURVEY BANKS DURING 1976-1987 Ill. The Ex Post Profitability of the Credit D THE SPREAD BETWEEN CREDIT CARD INTEREST RATES AND THE COST OF FUN As seen in Section I, the credit card m ket of the 1980,'s possessed most of the Inte orea te usual prerequisites for invoking the model Year percentage (percentage) of perfect competition. A perfectly competi- 10 run economic profits for“ marginal”frms. 10.36 Moreover, since free entry into the industry 1979 is possible and no input appears to be in scarce supply, there is no credible source of rents to distinguish“ inframarginal” firms from"marginal"firms. Thus, the competi tive model would predict that all credit card issuers earn zero long-run economic profits 11.55 Many models of imperfect competition which preserve the free-entry assumption Source: Author 's bank credit card survey (Appendix a, would also yield the zero-profit prediction Table Al, questions 7 and 1). By way of contrast, the interest rate stick iness documented in the previous section suggests that credit cards must become ex- ts marginal default rate equal to the dif- traordinarily profitable whenever the cost of ference between the interest rate it charges funds drops. Indeed, in this section, I will and the marginal cost (net of defaults) of present a rather paradoxical set of data lending funds. (The net marginal cost should which indicates that returns from the credit equal the cost of funds plus a constant that card business were several times greater is fairly stable in the short run. )Thus, the than the ordinary rate of return in banking prediction is that an optimizing bank should during the years 1983-1988 set its marginal default rate equal to the At the same time this profitability data dent reason why credit card interest rates interpreted. On do u that the above evidence interest rate spread plus a constant. will help to assure Suppose now that there is an indeper of interest rate stickiness has been correctly might have thought to ar- fail to fall when general market interest gue that price rigidity is consistent with rates decline(for example, see Section VI below ). The logic of the previous paragraph dictates that loan losses will subsequently cards, there is stickiness despite a deregulated increase. If firms do not compete and drive environment. Second, under regulation, the airlines price down toward marginal cost, they are appi Free entry is, a reasonable depiction of a credit ently competed away their profits. likely instead to compete and drive marginal card market in which 4,087 banks (and other deposit cost up toward price, o in the form of is ing cards to less credit-worthy customers institutions) already issued their own Visa card similar (largely overlapping) number issued thei Master Cards in September 1987. All of these instit ons could legally offer accounts to customers any where in the United States. Nonmember institutions LA related argu could join the Visa system by paying a fairly trivial eorge w. hat the ci rd's one thousand dollars, according to a visa official (Only price regulations, at a time when the introduction of jet the assets of the subsidiary that issues the cards, and engines reduced the fundamental cost of air trans- not the assets of the holding company are figured into portation es to compete and drive this formula. Furthermore, it would seem strained to p to price by er passengers o n requires airplane. The ar many years or tha put is in supply, given First. in the airli the deluge of cre solicitations made by banks in been caused by price regulation, whereas with credit recent years This content downloaded from 202. 120. 224.93 on Sun. 17 Dec 201707: 42: 57 UTC Allusesubjecttohttp:/about.jstor.org/terms56 THE AMERICAN ECONOMIC REVIEW MARCH 1991 TABLE 4-LoAN LOSSES ON CREDIT CARDS OF TEN SURVEY BANKS DURING 1976-1987 (FEWER THAN NINE DURING 1976-1978 AND 1986-1987) AND THE SPREAD BETWEEN CREDIT CARD INTEREST RATES AND THE COST OF FUNDS Average charge-off Interest rate rate spread Year (percentage) (percentage) 1976 1.15 10.57 1977 0.99 10.36 1978 1.27 8.11 1979 1.44 5.78 1980 2.04 5.08 1981 1.48 2.94 1982 1.67 6.42 1983 1.32 8.79 1984 1.36 7.69 1985 1.94 9.82 1986 3.01 11.55 1987 2.60 10.43 Source: Author's bank credit card survey (Appendix A, Table Al, questions 7 and 1). its marginal default rate equal to the dif- ference between the interest rate it charges and the marginal cost (net of defaults) of lending funds. (The net marginal cost should equal the cost of funds plus a constant that is fairly stable in the short run.) Thus, the prediction is that an optimizing bank should set its marginal default rate equal to the interest rate spread plus a constant. Suppose now that there is an indepen- dent reason why credit card interest rates fail to fall when general market interest rates decline (for example, see Section VI, below). The logic of the previous paragraph dictates that loan losses will subsequently increase. If firms do not compete and drive price down toward marginal cost, they are likely instead to compete and drive marginal cost up toward price,16 in the form of issu- ing cards to less credit-worthy customers. III. The Ex Post Profitability of the Credit Card Market As seen in Section I, the credit card mar- ket of the 1980's possessed most of the usual prerequisites for invoking the model of perfect competition. A perfectly competi- tive model would at least predict zero long- run economic profits for "marginal" firms. Moreover, since free entry into the industry is possible and no input appears to be in scarce supply,17 there is no credible source of rents to distinguish "inframarginal" firms from "marginal" firms. Thus, the competi- tive model would predict that all credit card issuers earn zero long-run economic profits. Many models of imperfect competition which preserve the free-entry assumption would also yield the zero-profit prediction. By way of contrast, the interest rate stick- iness documented in the previous section suggests that credit cards must become ex- traordinarily profitable whenever the cost of funds drops. Indeed, in this section, I will present a rather paradoxical set of data which indicates that returns from the credit card business were several times greater than the ordinary rate of return in banking during the years 1983-1988. At the same time, this profitability data will help to assure that the above evidence of interest rate stickiness has been correctly interpreted. One might have thought to ar- gue that price rigidity is consistent with "A related argument was made in the context of airline regulation. George W. Douglas and James C. Miller (1974) argued that the Civil Aeronautics Board's price regulations, at a time when the introduction of jet engines reduced the fundamental cost of air trans- portation, led airlines to compete and drive their costs up to price by placing fewer passengers on a given airplane. The arguments differ in two important ways. First, in the airline industry, price rigidity may have been caused by price regulation, whereas with credit cards, there is price stickiness despite a deregulated environment. Second, under regulation, the airlines apparently competed away their profits. 17Free entry is a reasonable depiction of a credit card market in which 4,087 banks (and other deposit institutions) already issued their own Visa cards and a similar (largely overlapping) number issued their own MasterCards in September 1987. All of these institu- tions could legally offer accounts to customers any- where in the United States. Nonmember institutions could join the Visa system by paying a fairly trivial entry fee: six dollars per million dollars in assets, plus one thousand dollars, according to a Visa official. (Only the assets of the subsidiary that issues the cards, and not the assets of the holding company, are figured into this formula.) Furthermore, it would seem strained to argue either that adjustment to the "long run" requires many years or that some input is in scarce supply, given the deluge of credit card solicitations made by banks in recent years. 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