by Joanna Stavins
July/August 1996

Sticky interest rates on credit card plans have long been a mystery. One possible explanation is that banks maintain high rates because consumers' demand for credit card loans is inelastic. This study tests and rejects that hypothesis. Demand for credit card loans is found to be elastic with respect to interest rates charged, and the amount of delinquent loans is found to increase significantly more than total credit card loans when interest rates drop.

The results show that banks face an adverse selection problem: Lowering the annual percentage rate of interest (APR) would attract risky customers and increase delinquent loans at a significantly higher rate than 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. Consumers' demand is also found to be responsive to some of the enhancements added to the terms of credit card plans. Banks may find it optimal to charge high interest rates, while adding enhancements in order to attract customers and raise their income at a low cost.