The Free Lunch: Arbitrage Profits Associated with Credit Cards
Spencer, Austin H., Journal of Economic Issues
This paper explains the recent changes in the credit card contract, provides a summary of the literature, discusses the availability of arbitrage profits on introductory balance transfer offers, and explains why these offers exist.
In the early 1980's less than fifty percent of American families had at least one general-purpose credit card, today close to three quarters of American families hold at least one credit card. This growth in the number of credit cards outstanding has been matched by a four-fold increase in the total charges on credit cards from 1991 to 2006 (Mishkin 2007).
Growth in the use of credit cards is explained by several contributing factors. First, there appears to have been a shift in consumer preferences related to the convenience and security of using card forms of payment rather than cash (Johnson 2005). Second, the U.S. Supreme Court in the Marquette Decision (1978) paved the way for the elimination of price regulation allowing financial institutions to use risk-based pricing for credit cards (Scott 2007). Third, the development of credit scoring and risk-based pricing increased the use of credit cards by consumers that traditionally lacked access because of poor credit histories (Board of Governors 2006).
Credit cards have become a more complicated instrument at the same time that they have grown in popularity. In the 1980s, a credit card allowed the consumer to make purchases or obtain cash advances and applied a single APR to each feature. Fees were limited to a fee for cash advances, in some cases an annual fee, and a third fee if the customer paid late. In contrast, today a card may offer balance transfers and treat different classes of purchases and cash advances as different features, each with its own APR. All of the APRs adjust much more frequently to enable the card to adjust to changes in the market, changes in the customers risk profile, and the unbundling of the price of a credit card into a number of different rates and fees. The credit card today is also packaged with a variety of optional services (Furletti 2003).
The discussion of credit cards is broad and covers a variety of important institutional and analytical issues related to the credit card industry, credit card pricing, and bankruptcy.
The most recent discussion of the formation of the credit card industry, its structure and functioning of credit card networks and their modeling practices is found in Akers et al., (2005). Thomas Durkin (2000) provides a summary of information on the use of credit cards in the U.S.; long term trends in consumer indebtedness and consumer attitudes toward credit cards. Durkin (2002) finds that consumers have a variety of concerns regarding the clarity and desired simplification of information in credit card contracts. David Gross and Nicholas Souleles (2002) examine how consumers respond to credit availability and find that that an increase in credit limits result in a corresponding increase in debt levels. Shubhasis Dey (2005) finds that there is a threshold level of borrowing below which consumers prefer to use credit cards. Above that threshold, consumers use home equity lines of credit and consolidate all outstanding credit card debt into them. Paul Calem, Michael Gordy and Loretta Mester (2005) argue that persistence of high credit card rates is consistent with imperfect competition for high-balance customers, i.e., switching costs may arise because card issuers cannot readily distinguish between applicants intending to switch and those intending to accumulate more debt. They find that consumers with lower credit scores and large credit card balances find it more difficult to obtain better interest rates. Further, they find that adverse selection effects may compound these switching costs because those seeking to accumulate more debt are likely to have the strongest incentive to respond to a solicitation. …