Adverse Selection in the Credit Card Market

Abstract

Adverse selection is one of the most celebrated phenomena in the economics of information. Yet despite a burgeoning economics and finance literature consisting of literally hundreds of articles exploring the implications of adverse selection in credit markets, there remains little in the way of empirical studies which convincingly document the existence of adverse selection in credit markets as a real-world phenomenon. This paper examines the results of large-scale randomized trials in preapproved credit card solicitations for direct evidence of adverse selection. Four basic conclusions are reached. First, there is clear evidence of adverse selection on observable information: respondents to solicitations are substantially worse credit risks than nonrespondents. Second, comparing the customer pools resulting from different offers, solicitations offering inferior terms (e.g., a higher introductory interest rate, a shorter duration to the introductory offer, or a higher post-introductory interest rate) yield customer pools with worse observable credit-risk characteristics than solicitations offering superior terms. Third, there is also clear evidence of adverse selection on hidden information: even after controlling for all information known by the card issuer at the time the account is opened, customers who accept inferior offers are significantly more likely to default. Fourth, recipients of credit card solicitations appear to overrespond to the introductory interest rate relative to the duration of the introductory offer and to the postintroductory interest rate, consistent with the author's “underestimation hypothesis ” that consumers may systematically underestimate the extent of their current and future credit card borrowing. Send comments to:

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