An empirical investigation of pricing and competition in the UK credit card market

Knight, Helen Julie (2010) An empirical investigation of pricing and competition in the UK credit card market. PhD thesis, University of Nottingham.

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The UK credit card market has attracted significant interest since the late 1990s, partly because of the strong growth it has enjoyed and also because of the aggressive behaviour of a number of new entrants. The credit card market consists of two very different businesses: card issuance - the "consumer-end", which provides credit cards and bears the credit risk of the customer and merchant acquiring, and the "backroom business", which recruits outlets to accept credit cards and undertakes the processing of transactions. The two businesses are distinct and in the UK only a small number of firms operate within each segment. This thesis concentrates on issues connect to the card issuance business.

Credit card issuers bundle a wide range of characteristics into their product offering. Whilst this allows issuers to differentiate their product and better satisfy consumers who have heterogeneous preferences, the Office of Fair Trading has suggested that the bundling of characteristics makes informed choice problematic because consumers do not know the price of specific credit card characteristics. A hedonic pricing model with a two-level nested error component structure is estimated. It is found that individuals who hold either a student or an initial credit card are charged a risk premium by issuers. In addition, consumers must pay higher prices to hold credit cards with certain characteristics such as introductory balance transfer offers, an annual fee, a longer than average interest free period, particular loyalty schemes, or donate money to charities.

The research undertaken differentiates itself from the existing literature by testing for heterogeneities in the interest rate transmission mechanism by examining how retail credit card rates in the UK respond to changes in the Bank of England's base rate. Error-correction models are estimated to analyze long-run pass-through; long-run mark-up and the short-run spend of adjustment. A number of theoretical arguments have been put forward to explain why retail rate responses might be sluggish. These include tacit collusion between financial institutions, sunk/menu costs and dynamic price discrimination which relies on consumer inertia. Retail credit card rates are indeed found to be sticky and overshooting is commonplace. However, the adjustment process was found to vary considerably between depending upon card issuer and card type.

Asymmetries in interest rates have attracted considerable attention in the financial literature, thus the interest rate transmission mechanism is investigated further by examining sign asymmetry. No evidence of asymmetric pricing was found, which suggests that credit card issuers respond to base rate increases and decreases at the same speed.

The competitive price setting behaviour of UK credit card issuers is empirically analysed. A discrete choice framework is used to look for evidence of price leadership, or whether some banks systematically react to movements in input costs more quickly than other banks. No evidence is found to suggest that one issuer dominates the market and acts as a price leader or that different issuers are responsible for leading price movements in different directions. There is no general pattern of price (i.e. interest rate) leadership amongst leading issuers in the UK, however, the empirical findings do however suggest that issuers do interact with each other and that some leader follower behaviour is observed at the portfolio level.

Naturally, the work undertaken suggests some policy implications for regulators, consumer bodies and government agencies. Given that approximately 70 percent of all active accounts incur interest charges every month, consumers need to be provided with clear information and to be educated further in the benefits of shopping around. It is clear that the money transmission mechanism does not impact on credit card interest rates as well as it could do. Regulatory efforts are therefore required to help reduce interest rates in the light of a decrease in the base rate, thus helping credit card revolvers to decrease their debt burden.

Item Type: Thesis (University of Nottingham only) (PhD)
Supervisors: Amess, K.
Drake, L.
Keywords: Credit cards, credit card fees, Great Britain
Subjects: H Social sciences > HG Finance
Faculties/Schools: UK Campuses > Faculty of Social Sciences, Law and Education > Nottingham University Business School
Item ID: 12243
Depositing User: EP, Services
Date Deposited: 25 Oct 2011 09:55
Last Modified: 18 Dec 2017 17:50

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