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Adverse Selection in the Credit Card Market

This payment pattern contrasts with the monthly payments typically associated with AFDC/TANF and food stamps, and it may provide a way to gain addi- tional insight into the nature of credit markets and consumption behavior for low-income families. Our goal in section 3.5 is to summarize succinctly what has been done, to evaluate the strengths of this work, and to identify areas where addi- tional work could be useful to either verify existing conjectures or alter what we thought was known. In the final sections, we briefly discuss EITC-related policy debates and highlight what, if any, critical economic issues underlie these debates. We also briefly identify issues on which future research. | Adverse Selection in the Credit Card Market Lawrence M. Ausubel University of Maryland June 17 1999 Abstract Adverse selection is one of the most celebrated phenomena in the economics of information. Yet despite a burgeoning economics and finance literature consisting of literally hundreds of articles exploring the implications of adverse selection in credit markets there remains little in the way of empirical studies which convincingly document the existence of adverse selection in credit markets as a real-world phenomenon. This paper examines the results of large-scale randomized trials in preapproved credit card solicitations for direct evidence of adverse selection. Four basic conclusions are reached. First there is clear evidence of adverse selection on observable information respondents to solicitations are substantially worse credit risks than nonrespondents. Second comparing the customer pools resulting from different offers solicitations offering inferior terms e.g. a higher introductory interest rate a shorter duration to the introductory offer or a higher post-introductory interest rate yield customer pools with worse observable credit-risk characteristics than solicitations offering superior terms. Third there is also clear evidence of adverse selection on hidden information even after controlling for all information known by the card issuer at the time the account is opened customers who accept inferior offers are significantly more likely to default. Fourth recipients of credit card solicitations appear to overrespond to the introductory interest rate relative to the duration of the introductory offer and to the post-introductory interest rate consistent with the author s underestimation hypothesis that consumers may systematically underestimate the extent of their current and future credit card borrowing. Send comments to Professor Lawrence M. Ausubel Department of Economics University of Maryland College Park MD 20742 ausubel@econ.umd.edu 301 .