Subprime Consumer Credit Demand Evidence from a Lender's pricing E periment Sule alan College of Administrative Sciences and Economics, Koc University and CFAP Faculty of Business, Economics and Statistics, University of vienna and CEPR Using a unique panel data set from a U. K credit card company, we sensitivity of subprime credit card borrowers. In addition to all individual transactions and tails of a randomized interest rate experiment conducted by the lender on existing(inframarginal)loans For the whole sample, we estimate a statistically significant f3. 4 reduction in monthly credit demand in response to a five percentage point in interest rates. This aggregate response is small, but it masks very intere heterogeneity in the sample. We find that only low-risk borrowers who fully utilize their credit cards lower their credit demand significantly when faced with an increase rates. We also document that a five percentage point significant additional revenue for the lender without inducing delinquency over a short horizon. (JEL Dll, D12. D14) Borrowing rates affect firms'and households demand for credit. Quantifying such effects. that is estimating credit demand elasticities. has become an increasingly important academic endeavour. At the microlevel, lenders nterested in gauging these elasticities as an input to their optimal loan pricing strategies. At the macrolevel, knowledge of these elasticities is essential for understanding the transmission of monetary policy. Moreover, they can be We are grateful to the lender for sly providing us with the data We especially thank the lender's database ow, Nick Souleles and Philip Vermeulen, as well as participants of the Cambridge-Wharton conference, BCL- ECB conference cal Studies(IFS) and Bundesbank lysis and Policy( CFAP) and th ongyi Loranth, University of Vienna, 72 Bruenner Strasse 10 Vienna, Austria; telephone +431-4277-38052. E-mail: gyoengyi loranth@univie.acat. O The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. AllrightsreservedForPermissionspleasee-mail:journalspermissions@oup.com do:10.1093/rfs/hht029 Advance Access publication June 7, 2013 Downloadedfromhttps://academic.oupcam/rfs/article-abstract/26/9/2353/166253 e
[16:30 29/7/2013 RFS-hht029.tex] Page: 2353 2353–2374 Subprime Consumer Credit Demand: Evidence from a Lender’s Pricing Experiment Sule Alan College of Administrative Sciences and Economics, Koc University and CFAP Gyongyi Loranth Faculty of Business, Economics and Statistics, University of Vienna and CEPR Using a unique panel data set from a U.K. credit card company, we analyze the interest rate sensitivity of subprime credit card borrowers. In addition to all individual transactions and loan terms, we have access to details of a randomized interest rate experiment conducted by the lender on existing (inframarginal) loans. For the whole sample, we estimate a statistically significant £3.4 reduction in monthly credit demand in response to a five percentage point increase in interest rates. This aggregate response is small, but it masks very interesting heterogeneity in the sample. We find that only low-risk borrowers who fully utilize their credit cards lower their credit demand significantly when faced with an increase in interest rates. We also document that a five percentage point increase in interest rates generates significant additional revenue for the lender without inducing delinquency over a short horizon. (JEL D11, D12, D14) Borrowing rates affect firms’ and households’ demand for credit. Quantifying such effects, that is estimating credit demand elasticities, has become an increasingly important academic endeavour. At the microlevel, lenders are interested in gauging these elasticities as an input to their optimal loan pricing strategies. At the macrolevel, knowledge of these elasticities is essential for understanding the transmission of monetary policy. Moreover, they can be We are grateful to the lender for generously providing us with the data. We especially thank the lender’s database managers, who volunteered a great deal of assistance.We thank the editor (Alexander Ljungqvist) and the referees for their excellent comments. For comments and suggestions on the earlier versions, we are very grateful to Thomas Crossley, Alejandro Cunat, and Christian Laux. We also thank Orazio Attanasio, James Banks, Martin Browning, Russell Cooper, John Gathergood, Mark Jenkins, Soren Leth-Petersen, Valerie Lechene, Hamish Low, Nick Souleles and Philip Vermeulen, as well as participants of the Cambridge-Wharton conference, BCLECB conference, the EFA 2011 conference, and seminar participants at University of Cambridge, Koc University, University of Copenhagen, European University Institute, the Institute for Fiscal Studies (IFS), and BundesbankECB. This research is funded by the Cambridge Center for Financial Analysis and Policy (CFAP) and the University of Vienna. Send correspondence to Gyongyi Loranth, University of Vienna, 72 Bruenner Strasse, 1210 Vienna, Austria; telephone +431-4277-38052. E-mail: gyoengyi.loranth@univie.ac.at. © The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com. doi:10.1093/rfs/hht029 Advance Access publication June 7, 2013 Downloaded from https://academic.oup.com/rfs/article-abstract/26/9/2353/1662534 by Fudan University user on 14 December 2017
The Review of Financial Studies/v 26 n 9 2013 informative about whether households are credit constrained or whether they borrow responsibly and understand the basic credit terms offered to them. The latter point is particularly important because recent research documents low debt literacy and high financial vulnerability among a large number of households(see Lusardi and Tufano 2009). Such households are the primary concern of this paper. We estimate the sensitivity of credit demand to a large interest rate hike for individuals who are deemed to be subprime borrowers. We do this using a unique panel data set on credit card transactions from a private lender. Our lender serves only the subprime market in the United Kingdom. The strength of the paper relative to previous related studies is that we have access to a large exogenous change in interest rates. This variation is generated by the lender's randomized price experiment. To conduct the experiment, the lender classifies clients according to a behavior score that is designed to measure a clients riskness (low, medium, or high) and their utilization of credit cards (ow, medium, or high). This 3x3 classification produces nine"cells, and in five of these, the lender conducts a randomized experiment with a five percentage point interest rate increase. This setting not only allows us to dentify the causal effect of borrowing costs on credit demand for inframarginal loans but also gives us the opportunity to assess heterogeneity in treatment effects Subprime borrowers are commonly presumed to be credit constrained implying that they will not reduce borrowing in response to an interest rate increase. This argument lends itself to the conclusion that the interest rate increase necessarily leads to higher interest charges(revenue) for the lender and a faster debt accumulation for the borrowers. For the whole sample, we estimate a statistically significant f3.4 reduction in monthly credit demand in response to a five percentage point increase in interest rates. This aggregate response is small. We find no effect of the interest rate increase on the short-run probability of a client becoming delinquent. Together, the small reduction in monthly credit demand and the lack of an increase in delinquencies mean that the interest rate increase does lead to higher interest charges for the lender and no reduction in the stock of debt for the borrowers The finding that there is no reduction in debt despite the reduction in monthly credit demand is due to the fact that the increased interest rate applies to the entire stock of accumulated debt This overall pictur important heterogeneity the sample. We find credit demand reductions that are neither statistically nor economically different from zero among borrowers with high utilization rates and medium to high default risk. This is consistent with these particular borrowers being credit constrained. On the other hand, we estimate a ot disclose the name of the company. We will refer to it hereafter as the 2354 Downloadedfromhttps://academic.oupcam/rfs/article-abstract/26/9/2353/166253
[16:30 29/7/2013 RFS-hht029.tex] Page: 2354 2353–2374 The Review of Financial Studies / v 26 n 9 2013 informative about whether households are credit constrained or whether they borrow responsibly and understand the basic credit terms offered to them. The latter point is particularly important because recent research documents low debt literacy and high financial vulnerability among a large number of households (see Lusardi and Tufano 2009). Such households are the primary concern of this paper. We estimate the sensitivity of credit demand to a large interest rate hike for individuals who are deemed to be subprime borrowers. We do this using a unique panel data set on credit card transactions from a private lender. Our lender serves only the subprime market in the United Kingdom.1 The strength of the paper relative to previous related studies is that we have access to a large exogenous change in interest rates. This variation is generated by the lender’s randomized price experiment. To conduct the experiment, the lender classifies clients according to a behavior score that is designed to measure a client’s riskness (low, medium, or high) and their utilization of credit cards (low, medium, or high). This 3×3 classification produces nine “cells,” and in five of these, the lender conducts a randomized experiment with a five percentage point interest rate increase. This setting not only allows us to identify the causal effect of borrowing costs on credit demand for inframarginal loans but also gives us the opportunity to assess heterogeneity in treatment effects. Subprime borrowers are commonly presumed to be credit constrained, implying that they will not reduce borrowing in response to an interest rate increase. This argument lends itself to the conclusion that the interest rate increase necessarily leads to higher interest charges (revenue) for the lender and a faster debt accumulation for the borrowers. For the whole sample, we estimate a statistically significant £3.4 reduction in monthly credit demand in response to a five percentage point increase in interest rates. This aggregate response is small. We find no effect of the interest rate increase on the short-run probability of a client becoming delinquent. Together, the small reduction in monthly credit demand and the lack of an increase in delinquencies mean that the interest rate increase does lead to higher interest charges for the lender and no reduction in the stock of debt for the borrowers. The finding that there is no reduction in debt despite the reduction in monthly credit demand is due to the fact that the increased interest rate applies to the entire stock of accumulated debt. This overall picture does, however, mask some important heterogeneity in the sample. We find credit demand reductions that are neither statistically nor economically different from zero among borrowers with high utilization rates and medium to high default risk. This is consistent with these particular borrowers being credit constrained. On the other hand, we estimate a 1 For confidentiality reasons, we do not disclose the name of the company. We will refer to it hereafter as the “lender.” 2354 Downloaded from https://academic.oup.com/rfs/article-abstract/26/9/2353/1662534 by Fudan University user on 14 December 2017
Subprime Consumer Credit Demand statistically significant E9.0 reduction in monthly credit demand for borrowers with high utilization rates and low default risk. However, even for this group the response to the interest rate increase is not strong enough to lower the interest charges. In fact, despite their efforts, treated individuals in this group pay a 10%o higher interest charges relative to controls Borrowers with moderate utilization rate and "low default risk' also exhibit no sensitivity to higher interest rates. This is at first sight surprising because the unused borrowing capacity of individuals in this group suggests they are not credit constrained. These borrowers, however, had an increase in their credit limit just prior to the experiment. This increase make them appear to be borrowers who do not fully utilize their credit cards Hence, a potential interpretation of their behavior might be that the increase in credit limit relaxed their previously binding credit constraint. Their sitivity to the interest rate increase dir debt accumulation (E71, corresponding with a8.5% increase in total debt outstanding relative to the control) over three months following the interest rate Increase Estimating interest rate sensitivity of credit demand using survey data has been challenging for researchers This is because the cross-sectional variation in interest rates is likely to be endogenous to borrowing and repayment behaviors through unobservable characteristics of the borrowers Previous studies tried to overcome this challenge by using quasiexperimental designs. However, these research designs require strong identification assumptions. The experimental setting of our data gives us clean identification of credit demand elasticities without resorting to such assumptions. Moreover, the interest rate increase in ur data is substantial ( five percentage points)and the experimental sample size is large enough that we can be confident of detecting any economically Our study concerns a subset of households in a developed economy that are considered to be financially vulnerable. The U. K. credit market is a highly sophisticated market in which lenders have access to advanced risk pricing technologies. Such an environment allows access to formal credit (albeit at a high price) for households who would otherwise be rationed out. This access can provide insurance to temporary disruptions in households'income(such as 2 Attanasio, Goldberg, and Kyriazidou(2008)estimate interest rate elasticities of car loan demand by exploiting 四 nts for borowing rates. Adams. Eina v. and Levin (2oo9 se data on a u.s. privat sensitivity to loa tudy in which the authors find evidence of significant elasticity of credit card debt with respect to interest rates. Examples of identification assumptions include general exclusion restrictions for IV methods and common trend assumptions for difference-in-differences met 2355 Downloadedfromhttps://academic.oupcam/rfs/article-abstract/26/9/2353/166253 e
[16:30 29/7/2013 RFS-hht029.tex] Page: 2355 2353–2374 Subprime Consumer Credit Demand statistically significant £9.0 reduction in monthly credit demand for borrowers with high utilization rates and low default risk. However, even for this group, the response to the interest rate increase is not strong enough to lower the interest charges. In fact, despite their efforts, treated individuals in this group pay a 10% higher interest charges relative to controls. Borrowers with moderate utilization rate and “low default risk” also exhibit no sensitivity to higher interest rates. This is at first sight surprising because the unused borrowing capacity of individuals in this group suggests they are not credit constrained. These borrowers, however, had an increase in their credit limit just prior to the experiment. This increase makes them appear to be borrowers who do not fully utilize their credit cards. Hence, a potential interpretation of their behavior might be that the increase in credit limit relaxed their previously binding credit constraint. Their insensitivity to the interest rate increase directly translates into a significant debt accumulation (£71, corresponding with a 8.5% increase in total debt outstanding relative to the control) over three months following the interest rate increase. Estimating interest rate sensitivity of credit demand using survey data has been challenging for researchers. This is because the cross-sectional variation in interest rates is likely to be endogenous to borrowing and repayment behaviors through unobservable characteristics of the borrowers. Previous studies tried to overcome this challenge by using quasiexperimental designs.2 However, these research designs require strong identification assumptions. The experimental setting of our data gives us clean identification of credit demand elasticities without resorting to such assumptions.3 Moreover, the interest rate increase in our data is substantial (five percentage points) and the experimental sample size is large enough that we can be confident of detecting any economically significant effects. Our study concerns a subset of households in a developed economy that are considered to be financially vulnerable. The U.K. credit market is a highly sophisticated market in which lenders have access to advanced risk pricing technologies. Such an environment allows access to formal credit (albeit at a high price) for households who would otherwise be rationed out. This access can provide insurance to temporary disruptions in households’income (such as 2 Attanasio, Goldberg, and Kyriazidou (2008) estimate interest rate elasticities of car loan demand by exploiting the tax reform of 1986 in the United States. Alessie, Hochguertel, and Weber (2005) analyze the same issue using a similar design. Gross and Souleles (2002) use the U.S. Credit Bureau data and propose some firmspecific practices as instruments for borrowing rates. Adams, Einav, and Levin (2009) use data on a U.S. private subprime auto loan company. The general conclusion drawn from the studies is that there seems to be no sensitivity to borrowing rates among low-income households. However, such households display some sensitivity to loan features related to liquidity, such as down payment requirements, credit limits, and loan maturities. This finding is interpreted as the presence of binding liquidity constraints. The exception is the Gross and Souleles (2002) study in which the authors find evidence of significant elasticity of credit card debt with respect to interest rates. 3 Examples of identification assumptions include general exclusion restrictions for IV methods and common trend assumptions for difference-in-differences methods. 2355 Downloaded from https://academic.oup.com/rfs/article-abstract/26/9/2353/1662534 by Fudan University user on 14 December 2017
The Review of Financial Studies /v 26 n 2013 unemployment and sickness)and therefore can be beneficial. * However, access to high cost credit can pose a danger for financially fragile households if they borrow too much, relative to their means. The evidence reported in this paper provides novel insights on(1) the prevalence of liquidity constraints and(2) the mechanism of debt accumulation among subprime borrowers in developed economies. Such insights are critical to the development of public policy and consumer protection actions targeting financially vulnerable households in the United Kingdom and other developed economies From a policy point of view, the results illustrate(1) the vulnerability of subprime borrowers to interest rate increases and (2)that interest rate increases would be profitable for the lender for almost all types of borrowers studied.6 Whereas imposing interest rate caps might be an unpalatable option for a policy maker(because it could result in credit rationing), a range of other policy interventions might aid these individuals. These include restrictions on credit limit increases(particularly, limit increases initiated solely by the lender) and higher required minimum payments. A policy that requires lenders to fully explain and illustrate the consequences of higher interest rates on debt on might also be beneficial The rest of the paper is organized as follows. We provide a brief overview of the U. K. credit card market in the next section. In Section 2, we present our data and the experimental design. In Section 3, we motivate our outcome rariable and assess the magnitude of expected response to the experiment. We present and discuss the results in Section 4, and Section 5 concludes 1. Subprime Credit Card Market in the United Kingdom Credit cards have steadily grown in importance as a payment device in all industrialized countries. As of 2007, it is estimated that approximately 70 million credit cards were in issue in the United Kingdom. These cards were responsible for 22.4%o of the total consumer transactions, which stood at f540 billion in 2007(see Data monitor 2008). Moreover, borrowing on credit cards(revolving credit card debt from one month to the next and therefore incurring interest charges) has grown rapidly over the last few decades in the 4 Karlan and Zinman (2010) show that access to consumer credit even at very high rates can be beneficial.The ndomly assigned marginal loans produced significant net benefits for borrowers across a wide range of outcomes South afric emand elasticities in South Africa and Bangladesh, respectively. Karlan and maturity. Dehejia, ry, and Morduch(2012)estimate subtantial interest rate sensitivity among the poor. 6 A caveat applies to this result as the implications of the lender's profitability are based on short-run estimates. It is plausible that a permanent increase in interest rates has different long 2356 Downloadedfromhttps://academic.oupcam/rfs/article-abstract/26/9/2353/166253 e
[16:30 29/7/2013 RFS-hht029.tex] Page: 2356 2353–2374 The Review of Financial Studies / v 26 n 9 2013 unemployment and sickness) and therefore can be beneficial.4 However, access to high cost credit can pose a danger for financially fragile households if they borrow too much, relative to their means. The evidence reported in this paper provides novel insights on (1) the prevalence of liquidity constraints and (2) the mechanism of debt accumulation among subprime borrowers in developed economies. Such insights are critical to the development of public policy and consumer protection actions targeting financially vulnerable households in the United Kingdom and other developed economies.5 From a policy point of view, the results illustrate (1) the vulnerability of subprime borrowers to interest rate increases and (2) that interest rate increases would be profitable for the lender for almost all types of borrowers studied.6 Whereas imposing interest rate caps might be an unpalatable option for a policy maker (because it could result in credit rationing), a range of other policy interventions might aid these individuals. These include restrictions on credit limit increases (particularly, limit increases initiated solely by the lender) and higher required minimum payments. A policy that requires lenders to fully explain and illustrate the consequences of higher interest rates on debt accumulation might also be beneficial. The rest of the paper is organized as follows. We provide a brief overview of the U.K. credit card market in the next section. In Section 2, we present our data and the experimental design. In Section 3, we motivate our outcome variable and assess the magnitude of expected response to the experiment. We present and discuss the results in Section 4, and Section 5 concludes. 1. Subprime Credit Card Market in the United Kingdom Credit cards have steadily grown in importance as a payment device in all industrialized countries. As of 2007, it is estimated that approximately 70 million credit cards were in issue in the United Kingdom. These cards were responsible for 22.4% of the total consumer transactions, which stood at £540 billion in 2007 (see Data monitor 2008). Moreover, borrowing on credit cards (revolving credit card debt from one month to the next and therefore incurring interest charges) has grown rapidly over the last few decades in the 4 Karlan and Zinman (2010) show that access to consumer credit even at very high rates can be beneficial. The randomly assigned marginal loans produced significant net benefits for borrowers across a wide range of outcomes in South Africa. 5 The evidence on the credit elasticities of financially vulnarable households is limited, but there is a large body of academic literature on estimating credit elasticities in developing countries. Using a field experiement, Karlan and Zinman (2008) and, using between-branch variation, Dehejia, Montgomery, and Morduch (2012) provide evidence on the size of credit demand elasticities in South Africa and Bangladesh, respectively. Karlan and Zinman (2008) estimates modest interest rate sensitivity of the demand for new term loans in South Africa, with demand apparently more sensitive to loan maturity. Dehejia, Montgomery, and Morduch (2012) estimate subtantial interest rate sensitivity among the poor. 6 A caveat applies to this result as the implications of the lender’s profitability are based on short-run estimates. It is plausible that a permanent increase in interest rates has different long-run consequences, such as default or driving away clients. 2356 Downloaded from https://academic.oup.com/rfs/article-abstract/26/9/2353/1662534 by Fudan University user on 14 December 2017
Subprime Consumer Credit Demand United Kingdom attracting much attention from consumer protection groups, regulatory bodies, and, of course, the media. In 2007, total credit card debt stood at around f65 billion, representing approximately 30%o of consumer credit in the United Kingdom Consumers who are not considered suitable for unsecured credit by mainstream issuers comprise the U.K. nonstandard credit card market. The term"subprime "refers to a subsection of the nonstandard market in the United Kingdom. This subsection usually consists of individuals with adverse credit histories, that is, individuals with an even higher risk of default than the typical nonstandard individual Individuals deemed to be subprime borrowers are more difficult to evaluate in terms of default risk. This can be because of volatile income(e.g, many in this category are self-employed), low income (e.g unemployment ), lack of credit history in the United Kingdom, or impaired credit history due to past defaults or mortgage arrears. Therefore, lenders targeting this segment(such as our lender) invest heavily in advanced risk pricing technologies to combat the adverse effect of delinquencies and defaults The lenders randomized price experiments are part of its risk pricing practice 2. Data and Experimental Design Our data set is provided to us by a private credit card issuer, who is one of the major players in the subprime segment of the U. K. market. The data set comprises all individual transactions, including purchases, cash advances, payments, interest charges, and fees. We also have income, age, marital status, and home ownership reported by individuals at the application stage Our lender has routinely performed randomized interest rate experiments on ubsamples of clients since 2006. The main reason for these experiments is to establish sensitivity to interest rates as part of the companys risk pricing practice. Each experiment lasted between 3-6 months, and the lender initiated another experiment immediately following the previous one. Interest rate changes were permanent until the next change took effect. All interest rate experiments were designed based on ex-ante-determined blocks, which we will explain in greater detail later. The lender agreed to provide us with two of the experiments, called Phase 2 and Phase 6. As the later experiment, Phase 6, involved a much larger number of individuals and a much higher intensity of treatment(five percentage point increase in interest rates for all treated individuals), we chose to use these data. The experiment involved 39, 883 individuals. The randomization was done in November 2007, and the interest rate changes were communicated to the individuals allocated to treatment groups in January 2008. The interest rate changes were implemented 7 The main reason to fall into the subprime catagory is a County Court Judgement(CC))record. County Court judgement refers to an adverse ruling of the County Court against a person who has not satisfied debt payments with their creditors. An adverse ruling remains on the individuals record for six years from the date of judgement 2357 Downloadedfromhttps://academic.oupcam/rfs/article-abstract/26/9/2353/166253
[16:30 29/7/2013 RFS-hht029.tex] Page: 2357 2353–2374 Subprime Consumer Credit Demand United Kingdom attracting much attention from consumer protection groups, regulatory bodies, and, of course, the media. In 2007, total credit card debt stood at around £65 billion, representing approximately 30% of consumer credit in the United Kingdom. Consumers who are not considered suitable for unsecured credit by mainstream issuers comprise the U.K. nonstandard credit card market. The term “subprime” refers to a subsection of the nonstandard market in the United Kingdom. This subsection usually consists of individuals with adverse credit histories, that is, individuals with an even higher risk of default than the typical nonstandard individual. Individuals deemed to be subprime borrowers are more difficult to evaluate in terms of default risk. This can be because of volatile income (e.g, many in this category are self-employed), low income (e.g., unemployment), lack of credit history in the United Kingdom, or impaired credit history due to past defaults or mortgage arrears.7 Therefore, lenders targeting this segment (such as our lender) invest heavily in advanced risk pricing technologies to combat the adverse effect of delinquencies and defaults. The lender’s randomized price experiments are part of its risk pricing practice. 2. Data and Experimental Design Our data set is provided to us by a private credit card issuer, who is one of the major players in the subprime segment of the U.K. market. The data set comprises all individual transactions, including purchases, cash advances, payments, interest charges, and fees. We also have income, age, marital status, and home ownership reported by individuals at the application stage. Our lender has routinely performed randomized interest rate experiments on subsamples of clients since 2006. The main reason for these experiments is to establish sensitivity to interest rates as part of the company’s risk pricing practice. Each experiment lasted between 3–6 months, and the lender initiated another experiment immediately following the previous one. Interest rate changes were permanent until the next change took effect. All interest rate experiments were designed based on ex-ante-determined blocks, which we will explain in greater detail later. The lender agreed to provide us with two of the experiments, called Phase 2 and Phase 6. As the later experiment, Phase 6, involved a much larger number of individuals and a much higher intensity of treatment (five percentage point increase in interest rates for all treated individuals), we chose to use these data. The experiment involved 39,883 individuals. The randomization was done in November 2007, and the interest rate changes were communicated to the individuals allocated to treatment groups in January 2008. The interest rate changes were implemented 7 The main reason to fall into the subprime catagory is a County Court Judgement (CCJ) record. County Court Judgement refers to an adverse ruling of the County Court against a person who has not satisfied debt payments with their creditors. An adverse ruling remains on the individual’s record for six years from the date of judgement. 2357 Downloaded from https://academic.oup.com/rfs/article-abstract/26/9/2353/1662534 by Fudan University user on 14 December 2017