The US credit card market is one of the largest debt markets in the world. In 2003 total bank credit card debt in the US amounted to $400 billion (source: FDIC Statistics on Depository Institutions). In comparison, the total size of the US corporate bond market in 2003 was $2500 Billion (source: Bank for International Settlements). However, when examining how debt markets function and price risk, the existing literature has focused predominantly on corporate debt. Much less attention has been paid to consumer debt in general and credit card debt in particular, despite the size of the credit card market.
This is the first paper to examine the determinants of credit card penalty fees. The most important such fees are late fees and overlimit fees. The rising level of these fees and their impact has been prominent in recent public policy debates in the US. For example, as part of his 2004 Presidential campaign, John Kerry called for credit card penalty fees to be regulated. Furthermore in March 2005 the US senate rejected a Democratic amendment to the Bankruptcy Bill (S 256) which, if passed, would have placed constraints on credit card providers’ ability to charge penalty fees.
The key element in this public policy debate is the issue of whether credit card penalty fees can be explained by factors such as cardholder default risk, or whether such penalty fees are “abusive” or “exorbitant” as claimed by opponents. For example, in their defense of credit card penalty fees the American Bankers Association has claimed that penalty fees compensate banks’ for the increased credit card risks they face. Until now, however, no formal study has been undertaken to validate or reject this claim.
Two different types of penalty fee are commonly charged by banks; late fees which are charged when borrowers repay after their due date and overlimit fees which are imposed when borrowers charge amounts that are larger than their pre-approved limits. For example, Chase Manhattan in 1998 charged a $20 overlimit fee and a $20 late fee while in 2002 it charged a $28 overlimit fee and a $28 late fee. A credit card borrower can be either late with a payment (i.e. a time dimension to the loan) or have charged an amount over their preauthorized limit (i.e. a dollar dimension to the loan) or both (in which case both the late and overlimit fees would be applied). It is important to note that in this paper we focus only on credit card penalty fees charged to consumers as a punishment for being late or overlimit and not other fees paid or received by credit card providers, such as the fixed annual fees paid up-front by credit card holders.
One reason for the increased focus on credit card penalty fees in recent public policy debates is the large dollar amounts involved. A recent survey found that penalty credit card fees in the US amounted to $13 billion in 2004 (RK Hammer Consulting Inc, 2004). Furletti (2003a) states that total late fee (i.e. not including overlimit fee) revenues in 2001 were $7.3 billion. As a proportion of bank credit card income, RK Hammer found that penalty fees accounted for 39% in 2004. Furletti (2003a) states that late fees (again not including overlimit fees) are the third largest revenue stream for card providers (following interest revenues and revenues received from merchants). These magnitudes clearly imply that credit card penalty fees are of substantial importance to both banks and their credit card borrowers.
Despite the significant public policy interest in card penalty fees as well as the large dollar magnitudes involved, this is the first paper in the literature to focus specifically on their determinants. Indeed, until now, the credit card literature has focused almost exclusively on credit card interest rates (e.g. Ausubel (1991), Brito and Hartley (1995), Calem and Mester (1995), Stango (2000), Stango (2002), Knittel and Stango (2003), Berlin and Mester (2004), Calem, Gordy and Mester (2005)). Penalty fees, however, are determined in a very different way than interest rates. Specifically, they are imposed only when a consumer is late or overlimit independent of time and dollar value.By comparison, card interest charges are increasing functions of both time and amount borrowed.
In section I of the paper, we provide further motivation for the importance of credit card penalty fees to banks (in addition to the evidence above on the large dollar revenues involved) by analyzing the impact of various proposed changes in card penalty fee regulations on the equity market values of US banks.
In section II of the paper, a theoretical model is used to motivate our empirical tests. The model provides four testable hypotheses. The first relates penalty fees to risk,the second relates to the substitutability of card penalty fees and interest rates, the third relates to the level of penalty fees and the level of consumer income and the fourth relates to the impact of credit card market share on penalty fees. Collectively, these hypotheses address the issues raised in the current public policy debate over the level and determinants of penalty fees. Specifically, it can be argued that if we find evidence that penalty fees are a function of (bank) market share, then public policy concerns could be raised regarding bank’s potential use of their market share to extract economic rents. Furthermore, evidence that banks charge higher penalty fees in lower income states could buttress arguments similar to those of Senator Kerry’s above. Alternatively, if we find evidence supporting penalty fees being based on consumer default risk and acting as substitutes for card interest rates, then this would provide support to the argument of the American Bankers Association that credit card penalty fees are determined by economic factors (e.g. risk and interest rates) and should not be subject to additional regulation.
In section III of the paper, we test these hypotheses using a unique data base developed from a number of primary sources. The core of our data base is the TCCP (Term of Credit Cards Plans) data base collected by the Federal Reserve. In addition we utilize a number of other data bases, including Bank Call Reports and the American Bankruptcy Institute consumer bankruptcy database, to derive measures of consumer risk, credit card market share and consumer income. Using three different econometric methodologies (2SLS, 3SLS and GMM) in order to control for endogeneity, we find strong support for our theoretical hypotheses concerning the effects of risk on penalty fees, as well as for the substitutability of penalty fees and interest rates. However, our evidence does not support the contention that consumers in poor (lower income) states pay higher penalty fees in comparison to those in rich states or that a higher bank market share leads to higher penalty fees. We do find, however, that market share (along with risk) does significantly impact the interest rates that banks charge on their credit cards. Thus, we can conclude that while the risk pricing argument of the American Bankers Association is broadly supported by the data on credit card fees, our data on credit card interest rates is consistent with both the risk pricing argument of the banks as well as the market share argument of bank critics.
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PDF The Cost of Being Late: The Case of Credit Card Penalty Fees
