Business Review Q3 2001 5www.phil.frb.org

A Summary of the ConferenceOn Consumer Transactions and Credit

I n March of this year, the Federal Reserve

Bank of Philadelphia and the Wharton

School of the University of Pennsylvania,

in association with the Journal of Financial Interme-

diation, sponsored a conference on research issues

involving consumer transactions and credit. This

article offers a summary of the papers presented at

the conference.

Consumers today have morefinancial options for saving, borrowing,spending, and investing than everbefore. Yet little is known aboutconsumers� decisions about how muchto save, which types of assets to invest in,how much to borrow, which types ofdebt to incur, and which instruments touse to make payments. Similarly, little isknown about how firms price thefinancial instruments consumers chooseto use. This intellectual neglect ofconsumer finance, and especiallyconsumer credit, is somewhat surprising,given that debt owed by householdsrepresents over 25 percent of totalcredit-market debt outstanding and thatthe outstanding volume of consumercredit, including mortgages, exceeds thevolume of U.S. government debt.

To begin to address these issuesand to encourage more research in thefield of consumer finance, the FederalReserve Bank of Philadelphia and theWharton Financial Institutions Center,in association with the Journal ofFinancial Intermediation, sponsored a

one-day conference at the PhiladelphiaReserve Bank on March 23. Fiveresearch papers and two addresses werepresented to an international group ofeconomists, who discussed consumercredit and transaction behavior. *

In his opening address toconference participants, Federal ReserveBank of Philadelphia President An-thony M. Santomero suggested that thelack of research on consumer financialbehavior in part �reflects the relativesimplicity of most U.S. householdportfolios before the 1990s. But anexplosive period of financial innovationin the last two decades and the rapidgrowth in consumers� wealth in the1990s have introduced many morehouseholds to many more financialoptions.�

President Santomero said moreresearch is needed. �This conference isjust the first of many efforts that we at

the Federal Reserve Bank of Philadel-phia plan to make to advance theconsumer credit research agenda,� hesaid. �We hope to shed light on the stateof research and to spotlight areas ofpotential future contributions.�

As he noted, the PhiladelphiaFed has a particular interest in the area,since some 40 percent of consumercredit card activity emanates fromDelaware banks in the Third FederalReserve District. To underscore thisinterest, the Bank has established aPayment Cards Center that will serve asa focal point for investigating issuescentral to this dynamic sector of thefinancial services industry. Theconference, proceedings of which aresummarized below, represents animportant first step in that direction.

CONSUMER RESPONSE TOCHANGES IN CREDIT SUPPLY

The credit card marketremains a relatively understudied areaof consumer finance. Nicholas S.Souleles, of the Wharton School,presented some interesting findings onthe behavior of credit card borrowers,concluding that liquidity matters. Hispaper, �Consumer Response to Changesin Credit Supply: Evidence from CreditCard Data,� co-authored by David B.Gross, formerly of the Graduate Schoolof Business, University of Chicago, isbased on analysis of a unique data set ofseveral thousand individual credit cardaccounts followed monthly for 24 to 36months. Souleles reported that accord-ing to their empirical work, �increases incredit limits for credit card borrowersgenerate immediate and significantincreases in debt,� especially for peoplewho are already close to their limit. This

* The papers are available on our web site atwww.phil.frb.org/econ/conf/program.html.

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suggests that these credit limits are abinding liquidity constraint. However,even people who have not borrowedenough on their credit cards to be neartheir limits start borrowing more whencredit card issuers increase their creditlimits.

This finding is consistent withtheories about precautionary savings.Consumers worry not only about creditconstraints that are already binding butabout the possibility that they will face abinding constraint in the future and willnot be able to borrow and consume asmuch as they would like. Consumerswant to keep some cash on hand,including some of their available credit,to act as a buffer against unexpectedemergencies. But when their creditlimits rise, only part of the increase isreserved for the buffer; it is optimal forthem to consume some of the increase.

Souleles indicated that some oftheir other results, however, are notconsistent with current theories ofconsumer savings behavior. For example,many of the people who are borrowingon their credit cards hold relatively largebalances in their low-interest checkingand savings accounts. Gross andSouleles found that �one-third ofborrowers have over one month�s worthof income in liquid assets, which is morethan typically needed for cash transac-tions.� These funds could be used topay off high-interest credit card debtwithout sacrificing much interestincome.

Another interesting result isthat in contrast to most other studies,their research also indicates thatconsumers� credit card debt is particu-larly sensitive to changes in credit cardinterest rates, especially to large declinesin rates. This might explain thewidespread use of teaser rates. Thediscussant, Paul S. Calem, of theFederal Reserve Board, suggested thatfurther analysis of the effect of teaserrates on credit card borrowing would bean interesting avenue for future

research. Souleles said their analysis alsoshowed that consumers seem to respondto a reduction in a credit card rate byswitching balances from other cards tothe low-rate card. So consumers appearto be sensitive enough to interest ratechanges to overcome the costs associ-

ated with switching balances from onecard to another. Such switching costswere the subject of another paperpresented at the conference.

ESTIMATINGSWITCHING COSTS

One of the factors oftenpointed to in explaining why credit cardinterest rates are relatively sticky andgenerally only somewhat responsive tochanges in market interest rates is thatthere appear to be large costs associatedwith switching accounts. But theseswitching costs have been difficult toquantify. In �Estimating Switching Costsand Oligopolistic Behavior,� Moshe Kimand Doron Kliger, both of the Universityof Haifa, and Bent Vale of the CentralBank of Norway, present a method forestimating switching costs for bankcustomers. Their research is based onaggregate data, since customer-specificinformation is typically not available.

In his presentation, Kimdiscussed the theoretical literature onswitching costs, which indicates howsuch costs can influence firms� pricingbehavior. But because micro-level dataon individual transactions are nearlyimpossible to come by, researchers havehad difficulty in estimating the magni-

In contrast to most other studies, [Gross andSouleles�] research also indicates that con-sumers� credit card debt is particularly sensi-tive to changes in credit card interest rates,especially to large declines in rates.

tude and significance of switching costs.In their paper, the authors develop anempirical model that is able to quantifythe importance of switching costs as wellas customers� probabilities of switchingfrom one firm to another, even whencustomer-specific data are absent.

The model, which wasestimated using aggregate data on banksthat operated in Norway from 1988 to1996, focused on the market for bankloans. Bank lending is a good candidatefor study, since long-term relationshipsand repeated contacts among banks andtheir customers � factors that charac-terize bank lending � may be a sourceof switching costs.

The study�s empirical resultsconfirm the importance of switchingcosts in bank lending, with the esti-mated magnitude of switching costsdiffering across various subsamples of thebanks. For the entire sample, switchingcosts average 4.1 percent, which is aboutone-third of the market average interestrate on loans. But switching costs arefound to decrease with bank size, downto 2.1 percent for banks with 60 or morebranches. This decrease in the size ofswitching costs may occur because thecustomers of large banks tend to be largecompanies. These firms are oftenpublicly traded and enjoy greatermarket mobility than small retailcustomers. Consistent with this result isthe finding that in the sample, custom-ers� relationships with their banks rangedbetween 16.7 years at small banks downto 11.3 years at large banks. Kim and his

Business Review Q3 2001 7www.phil.frb.org

co-authors also find that the customerlock-in generated by the switching costsis valuable to banks: locked-in custom-ers add nearly 25 percent to banks�value.

The discussant, Steven A.Sharpe, of the Federal Reserve Board,suggested that the authors try tomeasure the loan price-cost margin moreprecisely, since it is a crucial variable intheir model. In particular, Sharpe wasconcerned that the measure used couldreflect differences in loan risk, whichcould differ by bank size, as well asdifferences in market power, and thatthe imprecise measurement of the price-cost margin could be influencing theresults.

BANK CONSOLIDATIONAND CONSUMER LOANINTEREST RATES

Another paper at the confer-ence also examined banks� loan pricingbehavior. In �Bank Consolidation andConsumer Loan Rates,� Charles Kahnand George Pennacchi, of the Univer-sity of Illinois, and Ben Sopranzetti ofRutgers University, examine whetherbanks change their pricing of consumerloans after bank mergers and whetherthe pricing behavior differs for differenttypes of consumer loans.

The recent wave of mergers inthe banking industry has spurred anumber of researchers to examine theimpact of mergers on potentiallyvulnerable bank customers. But asSopranzetti explained, to date, moststudies have focused on the supply andpricing of small-business loans andconsumer deposits. In their paper, theauthors shed new light on the effect ofbank consolidation on the pricing ofauto loans and unsecured personalloans.

In particular, while rates onpersonal loans tend to rise at banks inthe market following a bank merger,rates on automobile loans tend to fall.The authors attribute this difference to

the scale economies that exist in theauto loan market and the fact that thereis strong competition from nonbanklenders for auto loans; hence, themerger does not represent an increase inbanks� market power in the auto loanmarket. Thus, consumers in the marketfor new auto loans are likely to benefitfrom a merger, since prices fall, whilethose seeking unsecured personal loansare not likely to see better pricingoptions.

Sopranzetti reported on otherfindings of their analysis: (1) Leader-follower pricing behavior is morewidespread in automobile loan marketsthan in personal loan markets. In otherwords, if one bank changes its auto loanrate, other banks are likely to follow it bychanging their rates. This is consistentwith the greater competition found inauto loan markets. The authors suggestthat higher consumer switching costs inthe personal loan market might makethe personal loan rate set by a givenbank less responsive to its competitors�rates. (2) Personal loan rates are stickierthan automobile loan rates, in the same

are slower to lower consumer loan rateswhen warranted by declines in othermarket rates than they are to raiseconsumer loan rates when other marketrates rise.

The discussant, Leonard I.Nakamura, of the Federal Reserve Bankof Philadelphia, indicated that personalloans are much more heterogeneousacross banks than are auto loans andthat this might be influencing theresults. He also suggested that having atheory about how banks� pricingbehavior would change after a mergerwould be helpful in interpreting theresults. Conference participantssuggested that a more completeconsideration of market competitionwould be a useful extension. Forexample, how do the special characteris-tics of auto finance subsidiaries affectthe bank market for auto loans? Howdoes unsecured credit card debt comeinto play in understanding the marketfor personal bank loans?

PERSONAL BANKRUPTCYAND THE LEVEL OF ENTREPRE-NEURIAL ACTIVITY

Another area relevant to thestudy of consumer finance is the issue ofbankruptcy. In �Personal Bankruptcyand the Level of EntrepreneurialActivity,� Wei Fan of the University ofMichigan and Michelle J. White of theUniversity of California San Diegoexamine the effect of the provisions inbankruptcy law on entrepreneurialactivity. Their paper is fitting for aconference on consumer finance, since,in many cases, it is very difficult todisentangle a small business�s financesfrom that of the owner�s.

Small businesses, as well asconsumers, can file for bankruptcyunder Chapter 7 of the federal bank-ruptcy code. Debts of noncorporatefirms are considered personal liabilities ofthe entrepreneur/owner in the event ofa business failure. The law requires thatthe entrepreneur give up assets above a

While rates on per-sonal loans tend torise at banks in themarket following abank merger, rates onautomobile loans tendto fall.

way that consumer deposit rates tend tobe sticky, that is, not very responsive tochanges in the overall level of marketinterest rates. And, consistent withempirical research on consumer deposits,personal loan rates are more rigid inmore concentrated markets. (3) Bothautomobile and personal loan rates tendto respond asymmetrically to increasesand decreases in market rates. Banks

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fixed bankruptcy exemption level forrepayment to creditors, but all theirfuture earnings are exempt from theobligation to repay. This �fresh start�provision lowers the ultimate risk ofstarting a business, since more of theentrepreneur�s assets will be protected inthe event the business fails. So theexemption provides a form of �wealthinsurance� to the business owner, andhigher exemption levels could poten-tially encourage the formation of morenew businesses. The fact that theexemption levels are set by states andvary widely, especially the exemption forthe debtor�s house (the homesteadexemption), provides a natural labora-tory for studying whether bankruptcyexemptions have a significant economiceffect on entrepreneurship.

The authors find empiricalsupport for the idea that the bankruptcysystem is a factor in a worker�s decisionto be self-employed rather than to workfor others. Fan and White find: (1) Theprobability that families that own homesare self-employed is 35 percent higher iffamilies live in states with unlimitedhomestead exemptions rather than lowexemptions. (2) Families that arehomeowners are 22 percent more likelyto start businesses if they live in stateswith higher or unlimited, rather thanlow, homestead exemptions. And theyare more likely to organize theirbusinesses as noncorporate rather thancorporate. (3) One possible negativeeffect of higher exemptions is that theymay encourage more bankruptcy filings,but the authors do not find thatentrepreneurs are more likely toterminate businesses if they live in stateswith unlimited rather than low home-stead exemptions.

In her presentation, Whitecommented on the proposed newfederal bankruptcy legislation andpossible implications based on thisresearch. The proposed legislationfocuses on reducing abuses by relativelywell-off individual debtors. However,

Fan and White�s research suggests anunintended consequence of adoptingthese reforms could be a reduction inthe level of self-employment by U.S.households.

The discussant, MitchellBerlin, of the Federal Reserve Bank ofPhiladelphia, generally applauded thepaper for extending what is generallyconsidered a consumer issue to theenvironment of small business andentrepreneurship. At the same time, healso made the point that while highexemptions may support small-businessformation, they may just as likely reducethe supply of credit to borrowers, whichwould mitigate any positive effect onsmall-business formation. In addition, hepointed out that it was still an openquestion whether self-employmentnecessarily means more economicgrowth or whether it reflects employ-ment redistributed from larger firms.

THE COSTS AND BENEFITSOF TRANSACTIONS PRIVACY

Another issue that�s becomeincreasingly important to consumers iswhether the privacy of their transactionsis being protected. Rapid advances ininformation technology have dramati-cally lowered the cost and increased thespeed of record keeping and transmis-sion of information. The Internet hasnot only affected the cost of transmit-ting information but also broadened thenature of potentially available informa-tion, including information stored onpersonal computers. All of these factorshave led to undeniable increases inconvenience and welfare to consumers,but they have also fueled the publicdebate on privacy, particularly Internetprivacy.

In their paper, �A Theory ofTransactions Privacy,� Charles M. Kahn,of the University of Illinois, JamesMcAndrews, of the Federal ReserveBank of New York, and WilliamRoberds, of the Federal Reserve Bank ofAtlanta, develop a model to examine

the tradeoffs between the costs andbenefits of transactions privacy. In theirmodel, privacy means the concealmentof potentially useful information, butconcealment also potentially bestowsbenefits. As long as contracting isflexible and the initial rights to the

information are clearly assigned, Coase�stheorem would suggest that privacy lawswould not be necessary. Once propertyrights are initially assigned to a party(either one), the parties will bargain,making appropriate side payments toone another, so that the outcome chosenregarding whether to reveal or concealinformation will be the one that has thelargest total benefit to both parties. (Theinitial assignment of rights will affect thedistribution of those benefits.)

However, the authors arguethat there are good reasons to believethat the assumptions of Coase�s theoremwouldn�t apply in our current transac-tions environment. For example, it isdifficult to commit to not using informa-tion once it becomes known, andcurrently, neither the law nor technol-ogy clearly assigns rights to transactionsinformation. The authors show that inthe current environment, the initialassignment of rights over privateinformation could have economicconsequences.

As McAndrews pointed out inhis presentation, murky rights to trans-

Rapid advances ininformation technol-ogy have dramaticallylowered the cost andincreased the speedof record keeping andtransmission of infor-mation.

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action information provide incentives forparties to develop technologies to controlinformation. This could result in a raceto create technologies to concealinformation (for example, anonymouselectronic money) or to reveal informa-tion (for example, Internet �cookies�).Clearly defining rights to transactioninformation would forestall wastefulinvestments in technology to controlinformation.

William L. Lang, of the Officeof the Comptroller of the Currency,complimented the authors on develop-ing a formal model with which to

address the privacy issue. He didquestion whether the model was richenough for policy analysis. For example,in the model, parties are assumed to beaware of when transaction informationis disclosed and what information isdisclosed. However, in many cases,people do not know that information hasbeen disclosed. While the Gramm-Leach-Bliley Act requires financialinstitutions to disclose informationsharing, nonfinancial firms are notrequired to do so. Lang also thought thatthe paper overstated the rights ofconsumers under Gramm-Leach-Bliley.

PAYMENT SYSTEMCOMPETITION

Jean-Charles Rochet, ofToulouse University, France, presentedthe conference�s keynote luncheonaddress, �Payment Systems Competi-tion.� Rochet�s talk was based on hisongoing research on payment systems,which he is carrying out with hiscolleague Jean Tirole. His remarksfocused on their research-in-progress oncompetition between different types ofpayment systems: those structured asopen associations of banks, like Visa andMasterCard, and those structured asclosed systems, like American Expressand Discover. An important and stillunanswered question is whether suchcompetition will lead to more efficientusage of payment cards. The Rochet-Tirole model is an important contribu-tion to the study of payment systems,and it is applicable to other environ-ments, such as competition betweeninterbank large-value payment systemslike CHIPS and Fedwire, or competitionbetween credit cards and debit cards.

SUMMARYThe research on payment

systems by Rochet and Tirole, alongwith the other work presented anddiscussed at the conference, representsan important step in meeting thechallenge posed by President Santomeroin his opening address to the confer-ence. In discussing the current state ofthe literature, President Santomeroemphasized that �we need to developnew theories if we hope to explain theeconomic rationale for and the impactof various transactions media, like creditcards, debit cards, and smart cards,which are much more complicated thanour traditional characterization ofmoney.� We hope that this conferenceand the work of the Federal ReserveBank of Philadelphia�s Payment CardsCenter will inspire other researchers tojoin in this effort. BR