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FED ECONOMIST NOTES HIGH RISK FACTOR IN CREDIT CARD RATES

 FED ECONOMIST NOTES HIGH RISK FACTOR IN CREDIT CARD RATES
 SAN FRANCISCO, Nov. 26 /PRNewswire/ -- High credit card rates are consistent with the pricing of risky credits in an atmosphere of moral hazard and costly collateralization of service, said an economist for the Federal Reserve Bank of San Francisco.
 "Attempts to reduce credit card rates through usury legislation will have the effect of exposing banks to increased risk and reducing the availability of consumer credit," wrote Randall J. Pozdena in the Bank's Weekly Letter of Nov. 29. "This is a curious policy direction in an economy already plagued by weak financial institutions and sluggish credit growth."
 Pozdena, vice president of banking and regional studies at the Reserve Bank, said credit card rates have responded sluggishly, if at all, to trends and fluctuations in other market interest rates. Combining this with the fact that there are at least 5,000 credit card issuers in the United States could suggest that credit card lenders reap abnormally high profits.
 But, Pozdena argued, the high rates make sense because they compensate credit card issuers for facing sizeable risks in offering unsecured debt (no cardholder assets are pledged on the card's revolving credit), high service costs, and the risk of extreme fluctuations in the cardholder's net worth.
 "Banks can (and do) impose limits on credit card credit as a means of controlling exposure," added Pozdena. "In addition, credit card companies try to identify consumer segments that pose lower risks of default (and these selective issuers charge lower rates).
 "But within any consumer segment, the lender can never be certain how leveraged the borrower has become because of other obligations, and because of the lack of collateralization, must assume 'worst case' exposure within each segment," creating the so-called "moral hazard of lending."
 The economist said the most practical solutions to the moral hazard problem are to collateralize the loan or to price the loan under the assumption of maximum risk exposure. That is, credit card debt interest rates must be set very high, even to creditworthy segments, in order to compensate the issuer for the fact that users will adjust their risk in response to the price of the credit.
 "Indeed, if there is no way to limit the moral hazard problem, no rate would be high enough," he added. "As a practical matter, of course, the reputational costs associated with a bad credit rating help cap extreme behavior of borrowers."
 Using a model of poorly collateralized debt derived from options theory, Pozdena reproduced the actual historical performance of credit card rates and concluded "that high and invariant credit card rates are not necessarily evidence of a failure of competition in the credit card market."
 -0- 11/26/91
 /CONTACT: Randall Pozdena of the Federal Reserve Bank of San Francisco, 415-974-3176/ CO: Federal Reserve Bank of San Francisco ST: California IN: FIN SU:


RM -- SF001 -- 7372 11/26/91 14:06 EST
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Publication:PR Newswire
Date:Nov 26, 1991
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