Credit card lending delivers a much higher return on assets than the banking sector, according to new research co-authored by Wharton finance professor Itamar Drechsler.
2 min. read
The top-of-mind question among credit card users is: “Why do they pay overly stiff interest rates?” Credit card interest rates average 23%—higher than any other type of loan or bond, according to a recent paper titled “Credit Card Banking” by Wharton finance professor Itamar Drechsler and other experts. The other authors of the paper include Wharton Ph.D. Dominik Supera, Wharton doctoral finance students Weiyu Peng and Guanyu Zhou, and others.
The authors analyzed four potential explanations for the high credit card rates. One, they are compensation for average default losses. Two, they cover the high costs of credit card “rewards,” which banks pay in cash or airline miles. Three, they price in a large default risk premium, because the risk of unexpected defaults cannot be diversified away and is high during bad economic times. And four, banks are able to charge high rates because they have market power.
The authors find that one of the main reasons for high rates was the amount of money card issuers spent on marketing “customer acquisition” to build their brands, thereby attracting customers and achieving pricing power. The study’s other findings support the case that operating expenses of card issuers—a large portion of which is spent on marketing—are a major contributor to the high interest rates. For instance, customer defaults are 5%, but even as they are high, they explain only about a third of the high credit spread in credit card interest rates. Card issuers also price in a default risk premium of 5.3%, which is similar to the risk premium priced into high-yield bonds.
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