Rev Ind Organ

DOI 10.1007/s11151-010-9258-4

An Empirical Analysis of UK Credit Card Pricing

Kevin Amess · Leigh Drake · Helen J. Knight

© Springer Science+Business Media, LLC. 2010

Abstract Previous studies show that the credit card market is imperfectly
competitive. Using a reduced form hedonic model, the current paper demonstrates
a relationship between credit card interest rates and product differentiation character-
istics. The characteristics capture issuers’ attempts to: (1) screen/separate customers
with different default risk characteristics and (2) better meet heterogeneous cus-
tomer preferences. The results are consistent with risk-based pricing and monopolistic
competition in the credit card market.

Keywords Credit cards · Pricing · Hedonic regression

JEL Classification D21 · L8

1 Introduction

The credit card industry continues to attract interest from economists (e.g., Agarwal
et al. 2010) seeking to explain the nature of its imperfections. Underlying this inter-
est is the question of why the price (interest rate) for an apparently homogeneous
commodity such as money in a seemingly competitive industry does not conform

K. Amess (B) · L. Drake

Nottingham University Business School, Nottingham NG8 1BB, UK
e-mail: kevin.amess@nottingham.ac.uk
L. Drake
e-mail: leigh.drake@nottingham.ac.uk

H. J. Knight
Nottingham Business School, Nottingham Trent University, Nottingham NG1 4BU, UK
e-mail: helen.knight@ntu.ac.uk

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to the predictions of the competitive model. Explanations have highlighted customer

heterogeneity (Ausubel 1991; Calem and Mester 1995; Agarwal et al. 2010). The
current paper argues that issuing banks offer credit cards with differentiated charac-
teristics in order to both sort and attract heterogeneous customers and demonstrates
the relationship between interest rates and card characteristics.1
Adverse selection theories based on switch and search costs have sought to explain
imperfections in the credit card market (Ausubel 1991; Calem and Mester 1995; Stango
2002; Berlin and Mester 2004; Calem et al. 2006; Agarwal et al. 2010). These theories
are based on the notion that low-risk customers are less likely to search and high-risk
customers are more likely to switch. Whilst these theories seek to explain price sticki-
ness and disincentives for issuers unilaterally to lower their interest rates, there is little
research that examines risk-based pricing. Calem et al. (2006) are a notable exception,
finding evidence of higher-default-risk customers’ paying higher interest rates.
Credit card attributes have been given scant attention in the literature, although
Stavins (1996) explores their implications on the demand for credit card loans. The
current paper seeks to offer insight on two aspects of product differentiation: First,
issuers supply some card attributes to deal with adverse selection and sort customers
on the basis of risk characteristics. The paper therefore seeks to add to our understand-
ing of risk-based pricing in the credit card market. Second, issuers offer a variety of
product attributes that consumers with heterogeneous preferences value differently.
The paper demonstrates how such attributes affect credit card interest rates, particu-
larly those attributes that attempt to induce switching and those that attempt to reduce
switching.
The paper uses data from the UK credit card industry. Both foreign and domestic
issuers offer a range of credit cards. There are no dominant issuers in terms of market
share with the largest three issuers (Royal Bank of Scotland/National Westminster,
Barclays, and HSBC) each having no more than 15% of the market in outstanding
balances. The largest foreign issuer is MBNA with a 9% market share in outstanding
balances (European Payment Review 2004–2005).
This paper is organised in the following way: Sect. 2 outlines theoretical issues
that relate to the economics of credit cards and card attributes. Section 3 explains the
modelling strategy. Section 4 describes the data set. The empirical results and their
implications are reported in Sect. 5, and conclusions are in Sect. 6.

2 The Economics of Credit Cards

This section outlines the economics of the credit card market. Particular emphasis is
given to explaining imperfections in the market and how they affect credit card inter-
est rates. In addition, supply- and demand-side factors in the credit card market are
discussed with reference to card attributes.

1 An issuing bank (referred to as the issuer) maintains the customer’s credit card account and is responsible
for reimbursing the merchant’s (or retailer’s) account (usually via an acquiring bank) when a credit card
purchase is made. The issuing bank then bills the customer for the debt. Typically, an issuer will provide a
range of credit cards that have different characteristics. These characteristics are discussed in later sections
of the paper.

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2.1 Search Costs

Issuers are able to charge high credit card rates because customers find it difficult to
obtain information in order to make comparisons. If search costs could be reduced,
there would be greater price competition (Berlin and Mester 2004). In 2003, UK
credit issuers introduced the summary box with marketing material in order to facili-
tate comparison between cards. Summary boxes are also provided on monthly credit
card statements. The summary box provides key information to consumers includ-
ing, inter alia, annual percentage interest rate (APR), minimum payment, when the
minimum payment is due, fees, and default charges (i.e., late fees). The summary
box therefore reduces search costs. However, Berlin and Mester (2004) do not find
evidence consistent with this type of search costs argument.
Ausubel (1991) suggests that there are low default risk borrowers that become
unintentional borrowers. When they borrow, they expect it to be on a short-term basis.
Therefore, they do not search for cards that offer low rates. Those customers that do
search for rates are higher risk, and any issuer that did lower its rates below that of
its rivals would attract higher risk customers. This adverse selection problem would
inhibit issuers from lowering their rates and provides a rationale for downward price
stickiness.
Ausubel (1991) theory provides the context for card issuers to provide loyalty
schemes (i.e., ‘cash back’, points, and discounts). Low-risk customers who do not
accumulate outstanding balances and use cards as a convenient method of payment
are not as profitable as are customers who accumulate balances (and who eventually
make full payment). Loyalty schemes induce increased card usage and might therefore
lead to customers’ becoming unintentional borrowers. Inducing indebtedness amongst
low-risk customers is more profitable than is offering lower rates that are attractive to
high-risk customers that are already in debt.

2.2 Switching Costs

Calem and Mester (1995) suggest that switching costs can induce an adverse selec-
tion problem for issuers in the credit card market in two ways: First, when customers
establish a good reputation with their current card issuer they are granted favourable
credit limits compared to those offered by a rival issuer. Second, customers with high
outstanding balances find it more difficult to switch because issuers are concerned
about default risk and are therefore more likely to reject their applications. Calem
et al. (2006) find evidence that is consistent with these propositions. Therefore, cus-
tomer indebtedness is an impediment to obtaining a card with lower rates. The concern
for issuers is that if they unilaterally lower their rates, it is the high-risk customers that
are likely to want to switch.
Previous studies have not considered the impact of reward and loyalty schemes on
card rates. Points and “air miles” loyalty schemes create switching costs because
the reward is non-transferable between cards. Customer lock-in can be exploited
by charging higher prices (Klemperer 1995). Therefore, if points and air miles
schemes create lock-in, these card attributes will be associated with higher rates. Their

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Table 1 Typical terms of different card types

Card type Average inter- Minimum Interest-free Minimum Credit limits

est rate (%) requirements period (days) repayments

Age Income (£) % £ Min (£) Max (£)

Platinum 12.98 25 25,000 56 2 5 5,000 50,000

Gold 15.48 21 15,000 56 2.25 5 500 10,000
Standard 15.81 18 0 56 2.25 5 None 50,000
Student 18.58 18 0 56 2.25 5 200 500
Starter 29.17 18 0 55 3.5 5 225 2500

effectiveness at creating customer lock-in, however, is limited by the fact that

customers can be multiple card holders. Such schemes are also likely to be a feature
of product differentiation and monopolistic competition and are therefore discussed
in section 2.4.
Chen (1997) suggests that the presence of switching costs can explain the practice
of paying customers to switch. Introductory offers on balance transfers and new pur-
chases for a fixed time period (typically 6-12 months) are effectively devices that
pay customers to switch. After the discount period ends the interest rate reverts to
the cards’ standard variable rate. Most providers charge fees for a balance transfer,
typically 2-3% of the value that is being transferred. Both types of offer are attempts
by issuers to increase their market share in outstanding balances. This might be due
to the maturity of the UK credit card market where growth is more likely to come
from appropriating rivals’ market share than from market expansion. Indeed, more
than 66% of the adult population in the UK have a credit card with an average of 2.4
cards per cardholder (APACS 2007).

2.3 Further Analysis of Adverse Selection and Risk

In order to attenuate the adverse selection problem that issuers face regarding custom-
ers’ likelihood of default, issuers use a variety of practices in order to sort customers
into different card types or reject their applications. These practices include: credit
scoring, gathering information on existing card balances, and determining employment
status. We do not have this information; however, we do observe cards of different
types that customers are sorted into on the basis of their risk characteristics.
From Table 1 it can be seen that interest rates vary widely depending on the card
type. The different APRs, to an extent, reflect the default risk that issuers place on
customers sorted into these different card types. Age and income are typically used
by issuers as important determinants of default risk. Thus in the context of risk based
pricing, the APR available to particular customers will tend to be a function of their
age and income. In addition, it can be seen that the minimum payment as a percentage
of the outstanding balance and the minimum and maximum credit limits are related
to credit card type.

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The minimum payment amount might also be used to attenuate adverse selection.
Customers less able to afford the minimum payment or those with higher default risk
will self-select towards a card with a lower minimum payment. Therefore, an issuer
has no incentive unilaterally to lower its minimum payment. Causality could equally
be in the reverse direction with riskier borrowers offered cards with a higher rate and
higher minimum payment.
Zywicki (2000) suggests that late payment and over-limit charges are principal
predictors of eventual default and that these “hidden fees” are targeted almost exclu-
sively at high default risk customers. The default fee, therefore, can be viewed as a
risk characteristic. Those cards including a higher risk premium in their rate would
also be charging higher annual fees as a deterrent to late payment and default.
In April 2006 the UK Office of Fair Trading announced that default charges were
generating in excess of £300 million a year for the industry and were significantly
higher than what is legally fair. However, if issuers are concerned about lower interest
rates attracting higher risk customers, they might seek to counteract this by charging
a higher default rate. Eliminating or lowering the default charge would therefore lead
to higher card rates.

2.4 Product Differentiation

Credit cards have a variety of characteristics from which customers can choose. There-
fore, customers facing a budget constraint will choose products with characteristics
that maximise their utility in characteristics space. Customers choose from differen-
tiated products containing bundles of characteristics with product prices determined
by those characteristics (Lancaster 1996). Product differentiation can give consumers
more choice and a greater variety of products with differentiating bundles of char-
acteristics allowing consumers to choose the bundle that is located closest to their
ideal bundle. Nevertheless, product differentiation can be used by sellers that seek to
dampen price competition in the face of heterogeneous consumer preferences (Shaked
and Sutton 1982).
The previous section considers card type from an issuer’s perspective in terms of
dealing with adverse selection. Card types (e.g., gold and platinum cards) are also
points of product differentiation and are potentially attractive to customers because
of the prestige in obtaining one. Their prestige depends on their availability. Table 1
shows that the average minimum income requirement for a gold card is £15,000
whilst it is £25,000 for platinum cards. If there is prestige attached to such cards,
customers would be willing to pay higher interest rates for the prestige of having a
gold card than a standard card. In turn, customers would be willing to pay more for a
platinum card than a gold card.2
As mentioned in section 2.2 points and air miles loyalty schemes might be a feature
of product differentiation. Other loyalty schemes include discounts on selected

2 From an issuer’s perspective we argue that gold and platinum card types will be associated with lower
interest rates, but from a consumer‘s perspective we argue that they will be associated with higher inter-
est rates. Unfortunately, due to data limitations, we are unable to estimate separate issuer and consumer
equations in order to explore fully these theoretical predictions.

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products and ‘cash back’. Customers with heterogeneous preferences will have dif-
ferent willingnesses to pay for different loyalty schemes. Consequently, customers
will pay higher rates for those attributes that they value most highly. The provision
of loyalty schemes is also costly to issuers, and so we would expect such costs to be
passed on to customers. Cards that offer ‘cash back’ on purchases might be favored
by consumers who use cards more for their payment services than for borrowing.
Cards with this attribute might therefore carry a higher rate to compensate for smaller
revolving balances.
Affinity and co-branded cards are a mechanism to generate loyalty, which helps sus-
tain a stable market share, and encourage customers to build large outstanding balances.
This might not lead to higher rates. Alternatively, they are also a characteristic that
allows issuers to differentiate their products from those of their rivals. Sometimes cus-
tomers receive benefits from the partner organization, and sometimes customers might
actually be demonstrating their loyalty to the partner organization—e.g., by using a
card with a football team logo on it. These arrangements are conducted at the issuer
level, and issuer fixed effects in a regression context can capture these characteristics.
Affinity and co-branded cards make charity donations in two ways. First, an amount
is given to the charity when the account is opened. Second, an amount donated per
£100 of expenditure using the card. Both these types of donation are observed and
included in the empirical model that is presented below. If the issuer seeks to main-
tain its profit margin, it will pass the cost of donation on to the cardholder via higher
interest rates.
Cards can be differentiated on the basis of the interest-free period they offer: the
period between a credit card transaction and the due date of the minimum monthly
payment. Credit cards allow customers to carry interest-free balances for up to two
months, as the cardholder is able to carry the balance interest-free not only during
the credit cycle, but for a number of days, typically around 25, after the initial credit
period has ended. Given that it is costly for issuers to offer credit, we suggest that a
longer interest-free period will be associated with higher interest rates.
Credit cards can also be differentiated on whether they charge fixed or variable rates.
In the UK, fixed rate credit cards are typically fixed for a period of five years. Stango
(2000) suggests that this is a feature of the credit market that will force issuers to change
their prices asynchronously where variable rate cards will change quickly in response
to the prime rate, which is the rate banks provide to their most creditworthy customers,
whereas fixed rate cards will only change their interest rate after the fixed rate period
ends. If LIBOR rises (falls) unexpectedly, then the price of fixed rate cards will be below
(above) that of variable rate rivals that change their interest rates in line with LIBOR.

2.5 Network Effects

A credit card connects customers and businesses via a payment system through which
electronic transfers of money are made.3 Issuers differentiate their credit cards within

3 In a credit card transaction, the customer’s bank that issues the credit card is called the issuer and
the merchant’s bank is called the acquirer. In order for a credit card transaction to take place the issuer and

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the payment systems to which they offer customers access. There are three payments
systems in use in the UK: Visa, MasterCard, and American Express (Amex). Custom-
ers gain greater network benefits from being part of the larger payment systems such
as Visa or MasterCard rather than Amex. Therefore, if customers value the network
effects of a credit card, they will be prepared to pay a higher price for them.
Typically, an issuer bundles a credit card with one of the payment networks. There
are a small number of cards, however, where issuers provide customers with a choice
of MasterCard or Visa at the point of application; henceforth, these are referred to as
MasterCard/Visa.

3 Modelling Strategy

Following the seminal work of Rosen (1974), hedonic regression models have become
an established way of examining how price dispersion is determined by different prod-
uct attributes. In order to determine and quantify how various card attributes affect the
price of the i th credit card in period t we employ a hedonic regression of the following
form:
Pit = α + βX it + γ LIBORit−1 + fi + εit , (1)
where P is the typical APR, X is a vector of card characteristics, LIBOR is the
London Inter-Bank Offer Rate, fi are issuer fixed effects that capture unobserved issuer
characteristics that are constant over time, ε is a stochastic error term, α is a constant
term, and the vector β and γ are unknown coefficients to be estimated.
The LIBOR is the rate that banks quote each other for overnight deposits and loans;
it represents the opportunity cost of an issuing bank’s assets. We lag the LIBOR by one
period (one month) and would expect that γ would be equal to one in a perfectly com-
petitive market; i.e., a change in the level of the LIBOR would rapidly pass through
into the card rate. Heffernan (2002) argues that this might not occur due to ‘menu
costs’: administrative costs that are associated with informing customers. It might
also not occur due to issuers’ exploiting product differentiation and risk attributes in
the vector X. The constant term will capture an interest rate mark-up; the fixed effects,
fi , capture differences in issuer-level mark-ups from the base group of issuers’ cards.
In the vector X we are able to include a variety of card characteristics. Dummy vari-
ables are included for platinum, gold, student, and initial credit cards with the base
card type being the standard/classic card. We predict that a risk premium is attached
to the offer of student and initial cards. Screening allows lower risk customers to be
offered platinum and gold cards at lower rates compared to standard cards.
Dummy variables are included for the MasterCard and Amex payment systems
with Visa being used as the base payment system. A separate dummy variable is
also included where customers have a choice between using the MasterCard or Visa

Footnote 3 continued
acquirer need to be connected by an electronic payment system, such as that provided by Visa, MasterCard,
and Amex. When a credit card transaction takes place and the issuer and acquirer are different, the acquirer
pays the issuer an interchange fee. The interchange fee on a transaction is akin to payment for access to an
electronic payments network. Detailed explanations of the economics of payment systems can be found in
Schmalensee (2002) and Rochet and Tirole (2002).

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payment system when they apply for a card. If the payment systems follow each oth-
ers’ prices, these variables will not be significant. We identify four different types
of loyalty schemes with dummy variables: cash back, points for using the card, air
miles, and discounts received with the card. The base group against which the loyalty
schemes are compared is the group of cards that offer no loyalty scheme.
Two variables that capture issuers’ investments in market share are the introductory
offer periods (in months) on balance transfers and new purchases. Predicated on the
notion that it is costly to issuers to make introductory offers and that cardholders will
not switch when the offer period ends, the greater is the offer period, the higher is the
price that is charged for the offer period. It should be noted, however, that because
introductory offers are devices that are used to steal market share from rivals and are not
available to all holders of a credit card, it might not be ‘priced’ in the usual way within
a hedonic regression. Indeed, a curious feature of these offers is that long-standing
customers with outstanding balances pay the higher interest rates on these cards but
do not get to take advantage of the introductory offers for new customers.
Also included in X is the interest-free period (measured in days), which is expected
to be positively priced. The default charge will be negatively associated with the APR
if it is used to support a lower APR than would be the case without a default charge.
If, however, the default fee is a risk characteristic targeted at high risk customers, it
will be positively priced. Whilst the reduced form model can inform as to which effect
dominates on the default fee, it is unable to provide information on the underlying
structural relationship that the contrasting predictions imply. A dummy variable that
is equal to one (zero otherwise) is included for cards that charge a fixed rate.
It is important to note important limitations in the modelling framework adopted.
Equation 1 is a reduced form from two structural equations: an equation for issuers
and an equation for potential and actual card holders. A more sophisticated model
might also provide for different motivations for product differentiation—e.g., better
meeting customer preferences and serving as screening devices. This would allow the
identification of economic primitives with respect to issuers’ costs and customers’
preferences, which is not possible in a reduced form model (Pakes 2003). Moreover,
it would provide a better treatment of the arguments that were outlined in Sect. 2.
Unfortunately, data limitations prevent the use of this type of modelling approach.

4 Data

The data set contains an unbalanced panel of 283 credit cards, which are observed
over a seven-month period between April 2006 and October 2006, inclusive. The data
set contains a total of 1880 observations with each card being observed for a minimum
of two months and a maximum of seven months. The sample attempts to reflect the
market characteristics of the UK credit card market. Cards were chosen on the basis
of being issued by one of the top 15 credit card issuers and on the basis of data avail-
ability. The top 15 credit card issuers in the UK account for approximately 90 percent
of the market in the terms of customer share.
The typical APR and card characteristics were collected from individual credit card
issuers’ websites and summary boxes. The summary box provides customers with
consistent and succinct summaries of the key features of a credit card, thus enabling

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customers to compare different credit cards more easily (APACS 2006). All integral
features of the credit card product, such as the interest-free period and introductory
rates are included in the summary box. Pre-contract, the summary box should appear
predominantly on or within any application form or promotional material with the
exception of television or radio promotional campaigns.
With respect to the Internet, a “click-through” to a page containing the summary
box is available. Information on free-standing or optional product features such as
loyalty programmes and payment protection insurance are not shown in the summary
box and were sourced from card providers’ websites.
The variables used in the empirical analysis are reported in Table 2 along with their
summary statistics.

5 Results

5.1 Findings

The regression results for estimating Eq. 1 are presented in Table 3. Columns (1)–(4)
report models that include issuer fixed effects. The issuer fixed effects are not jointly
significant at conventional probability levels in the model reported in column (4) and
so they are dropped in the model reported in column (5). For the models in columns
(1)–(4) we also conduct tests to determine if the coefficients on the issuer dummy
variables are equal. In columns (1)–(3) they are found not to be equal, though weakly
at the 8% level for column (3). This suggests that differences in unobserved organi-
zational characteristics are not associated with differences in interest rates. The issuer
dummy variables, however, are found to be equal in the results reported in column (4).
Column (1) presents results estimated using OLS. In column (2) we report the
results of two-stage GMM estimation of an instrumental variables model assuming
that the platinum card type, gold card type, and the minimum percentage payment are
endogenous. A difference in Sargan test statistic rejects the null hypothesis of exoge-
neity, providing support for our IV approach. The instrument set contains the excluded
instruments: minimum income, minimum age (and their squared terms), and the first
lag of the base rate. A Hansen/Sargan test of instrument validity is conducted, and the
rejection of the null hypothesis indicates the validity of the instrument set employed.
GMM estimation appears to affect coefficient estimates; however, many of the vari-
ables estimated by OLS are still significant using GMM. Our results provide support
for the argument that issuers sort customers into different card types according to
risk characteristics and charge customers different rates as a consequence. Customers
with platinum cards pay a typical APR that is 3.51% (351 basis points) lower than
customers with a standard card. Starter card customers, by contrast, pay a rate that is
6.29% (629 basis points) higher than those customers with a standard card.4

4 Following Rosen (1974), a coefficient estimate is often interpreted as the price of that characteristic, which
is equal to its marginal cost under competitive conditions. Pakes (2003) argues that the hedonic function
is the expectation of the marginal costs and the mark-up on ‘own product’ attributes. Once allowing for
mark-ups, the hedonic regression is a ‘reduced form’ that estimates correlations that arise from underlying
cost and demand parameters, interacting with market structure, with no obvious interpretation with respect
to any underlying structural relationships.

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Table 2 Summary statistics and variable definitions

Variables Definitions Mean Standard deviation

Price Typical APR 15.31 2.882

Fixed Interest rate type (0 if 0.065 0.246
variable, 1 if fixed)
Initial Initial credit card dummy variable 0.007 0.086
Gold Gold credit card dummy variable 0.049 0.216
Platinum Platinum credit card dummy 0.224 0.417
variable
Standard Standard/classic credit card 0.707 0.455
dummy variable
Student Student credit card dummy 0.013 0.114
Amex AMEX payment network 0.033 0.178
dummy variable
Master MasterCard payment network 0.318 0.466
dummy variable
MasterCard/Visa MasterCard or Visa payment 0.024 0.152
network dummy variable
Visa Visa payment network 0.625 0.484
dummy variable
Purchase offer Length of introductory offer 2.948 3.088
on purchases (months)
Balance transfer offer Length of introductory offer on 6.981 3.799
balance transfers (months)
Min. payment Minimum monthly payment (%) 2.249 0.354
Interest-free period Interest-free period (days) 54.347 6.363
Default charge Average default charge (£) 16.336 6.064
Points Points scheme dummy variable 0.095 0.293
Cash back Annual cash back received on 0.045 0.270
purchases (%)
Airmiles Air miles dummy variable 0.026 0.159
Discount Discount scheme dummy 0.116 0.321
variable
Donation when account Amount given to affinity 3.238 6.268
opened partner when account
opened (£)
Donations on spending Amount given to affinity 0.062 0.128
partner per £100 spent
on card (£)

The results for the different payment systems provide some support for customers
paying a premium for accessing larger networks and enjoying network externalities.
Whilst cards using the Visa and MasterCard payment networks are similarly priced
(cards using the MasterCard and MasterCard/Visa networks have rates that are 36 and

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 Table 3 Results (dependent variable = APR)

Variables (1) (2) (3) (4) (5)

OLS IV-GMM Random effects Random effects-IV Random effects-IV

Gold 0.33 (1.40) −0.37 (–0.42) 0.15 (0.28) −6.72∗ (–1.78) −0.95 (–0.64)
Credit Card Pricing

Platinum −1.39∗∗ (–7.71) −3.51∗∗ (–11.07) −1.43∗∗ (–4.66) −4.69∗∗ (–4.28) −2.96∗∗ (–3.92)
Starter 13.87∗∗ (12.65) 6.29∗ (1.65) 16.92∗∗ (12.26) 23.53∗∗∗ (2.36) 19.63∗∗ (2.82)
Student 3.60∗∗ (6.82) 1.38 (1.29) 2.66∗∗ (3.16) 2.19 (1.13) 3.30∗∗∗ (2.11)
Amex −1.07∗∗ (–2.85) −1.65∗∗ (–3.64) −0.04 (–0.03) −2.86 (–0.96) −2.08 (–1.07)
Master −0.38∗∗ (–3.52) −0.36∗∗ (–2.60) −0.19 (–0.67) −0.50 (–0.91) 0.26 (0.46)
MasterCard/Visa −0.98∗∗ (–3.72) −0.93∗∗ (–3.11) −0.83 (–1.20) −0.43 (–0.33) −0.75 (–0.60)
Balance transfer offer 0.15∗∗ (3.96) 0.26∗∗ (3.19) 0.08∗∗ (5.33) 0.10∗∗∗ (2.51) 0.07∗∗ (3.60)
Purchase offer 0.00 (0.09) −0.10 (–1.30) −0.16∗∗ (–10.46) −0.15∗∗ (–6.19) −0.16∗∗ (–10.28)
Min. Payment 0.90∗ (1.81) 7.00∗∗∗ (1.98) −1.62∗∗ (–8.76) −9.22 (–1.07) −3.04 (–0.89)
Donation when account 0.06∗∗ (5.16) 0.08∗∗ (4.09) 0.01 (0.62) 0.00 (0.03) −0.00 (–0.00)
opened
Donations on spending 1.88∗∗ (4.20) 1.15∗ (1.83) 3.22∗∗ (2.95) 2.62 (1.45) 4.13∗∗ (2.70)
Fixed −4.96∗∗ (–13.98) −3.44∗∗ (–9.79) −6.31∗∗ (–12.08) −4.12∗∗ (–3.79) −5.09∗∗ (–5.43)
Interest-free period 0.03 (1.64) 0.09∗∗ (5.72) 0.04∗∗∗ (2.03) 0.07∗ (1.68) 0.06∗∗∗ (2.20)
Default charge 0.01 (1.32) 0.01 (0.55) −0.01∗∗∗ (–2.25) −0.01 (–1.51) −0.01∗∗∗ (–2.50)
Points 0.73∗∗ (5.74) 0.14 (0.77) 0.04 (0.35) −0.02 (–0.09) −0.01 (–0.06)
Cash back 0.36∗ (1.65) 0.85∗∗∗ (2.29) −0.65∗∗∗ (–2.24) −0.39 (–0.69) −0.70 (–1.31)
Discount 0.66∗∗ (5.60) 0.37∗∗∗ (2.07) −0.02 (–0.07) 3.64 (0.82) 0.45 (0.16)
Airmiles 1.41∗∗ (4.30) 1.71∗∗ (3.29) 1.01 (1.44) 0.53 (0.44) 1.58 (1.42)
lnLIBORt−1 −0.03 (–0.07) −0.14 (–0.30) 0.34∗∗ (2.79) 0.34∗ (1.94) 0.36∗∗ (3.08)
Constant 10.91∗∗ (4.31) −4.73 (–0.49) 17.00∗∗ (11.99) 35.49 (1.60) 17.50∗∗∗ (2.47)
R2 0.68 0.49 0.62 0.32 0.52

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 Table 3 continued

Variables (1) (2) (3) (4) (5)

OLS IV-GMM Random effects Random effects-IV Random effects-IV

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Issuer dummy variables 6.405 66.87 27.04 17.64 –
[Prob] [0.00] [0.00] [0.02] [0.22] –
Issuers equal 5.44 63.72 20.64 13.59 –
[Prob] [0.00] [0.00] [0.08] [0.40] –
Endogeneity – 127.50 – 12.12 25.67
[Prob] – [0.00] – [0.99] [0.14]
Hansen-Sargan – 3.28e-05 – 0.588 0.0306
[Prob] – [0.99li] – 0.443 0.861
Notes: (1) ∗ p < 0.10, ∗∗ p < 0.01, ∗∗∗ p < 0.05; (2) it t-statistics reported in parentheses, they are robust to general forms of heteroscedasticity in columns (1) and (2);
(3) Issuer dummy variables is a test statistic [probability level] of the joint significance of the issuer dummy variables; (4) Issuer equal is a test statistic [probability level]
of the equality of the issuer dummy variables; Endogeneity is a test statistic [probability level] to determine whether the endogenous variables are actually exogenous;
(5) Hansen-Sargan is a Hansen/Sargan test statistic [probability level] of instrument validity
K. Amess et al.
Credit Card Pricing

93 basis points lower than the Visa network, respectively), Amex cards have a rate that
is 1.65% (165 basis points) lower than Visa. This is consistent with the Amex payment
system being smaller than its rivals and therefore offering a lower rate to compensate
for its smaller network effects.
Issuers will require a higher minimum payment from high-risk customers. Thus,
the minimum payment variable is capturing a risk attribute. The coefficient on this
variable in column (2) indicates that each percentage point increase in the minimum
payment is associated with the APR being 7% (700 basis points) higher. This mag-
nitude seems quite high; however, the variation in the minimum payment percentage
is not very high, and the APR could be sensitive to small differences in minimum
payment. For instance, if the minimum payment is one standard deviation higher than
the mean, the APR is 2.45% (245 basis points) higher than the average card.
Each £1 given to charity when an account is opened is associated with the APR
being 8 basis points higher. In addition each £1 given to charity per £100 spent on the
card is associated with a 1.15% (115 basis points) higher APR. This is only significant
at the 10% level and has stronger significance in the OLS model. Nevertheless, our
results generally support the notion that issuers’ affinity to charity organizations is a
strategy by which issuers can extract a price premium.
The OLS estimates indicate that all of the loyalty schemes that are captured in our
model are associated with a price premium. Points schemes are not significant, how-
ever, in the IV-GMM model. This model indicates that loyalty schemes are associated
with card rates that are between 0.37% and 1.71% points (37 and 171 basis points)
higher than cards with no loyalty scheme. Air miles is the scheme associated with
the highest price premium, suggesting that at least some customers have a greater
willingness to pay for this scheme than for the other types of loyalty schemes.
To counteract loyalty schemes and invest in market share issuers make introductory
offers on balance transfers and to new customers’ outstanding balances on purchases.
Both columns (1) and (2) indicate that the purchase offer is not significant. In con-
trast, the balance transfer offer is significant, and column (2) indicates it is associated
with the APR being 0.26% points (26 basis points) higher. Customers are not locked
in after the offer period, and so they can switch to another card with another issuer
that has an introductory offer. Inert customers that do not switch will pay the price
premium for the introductory offer on balance transfers.5
The coefficient on the interest-free period in column (2) indicates that each day
added to the interest-free period is associated with a card rate that is 9 basis points
higher. Cards offering fixed rates are associated with an APR that is 3.44% points (344
basis points) lower than variable rate cards. Depending on when the rate was fixed, it
either reflects that variable rates increased after the fixed rate was set, or it captures
issuers’ expectations of APRs declining in the future.
Whilst the results reported in columns (1) and (2) control for unobserved issuer
characteristics, they do not control for unobserved card characteristics. Additional

5 It should be noted that customers are to some extent restricted from behaving like what has become
known as a ‘credit card tart’ and switching between cards with introductory offers because issuers share
this information with credit bureaus, and a high number of card applications increases the risk of a card
application being rejected.

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 K. Amess et al.

models are estimated controlling for unobserved card characteristics in order to exam-
ine the effect on coefficient estimates. The error term in equation (1) will therefore
become:
εij t = ωj + υij t , (2)
where ωj is a random effect for the j th card that is assumed to be constant over time
and υij t is the residual. A random effects model is required because card fixed effects
would be perfectly correlated with the issuer fixed effects.
The models reported in columns (3), (4), and (5) employ the error structure
expressed in Eq. 2. The results in column (3) are estimated using GLS, and the
instrumental variables models in columns (4) and (5) are estimated using general-
ized two-stage least squares. Tests of endogeneity, however, reject the instrumental
variables random effects approach. The random effects models are generally support-
ive of the different card types (platinum, gold, standard, starter, and student) being
used to sort customers according to different risk characteristics. There is also support
for the previous findings on affinity via donations, fixed-rate cards, and the inter-
est-free period; however, loyalty schemes are not significant in the random effects
models.
Although the random effects models provide some evidence of LIBOR pass-through
to the card rate, the coefficient is relatively small, which indicates a relatively weak
relationship. Moreover, other models do not find that the LIBOR is statistically signif-
icant.6 This is consistent with ‘menu costs’ inhibiting changes in card rates because
issuers have to change their rates on both advertising material and credit card state-
ments.

5.2 Implications

On active credit cards over the sample period, the average outstanding balance is
about £1,504.7 With the use of this figure and estimates from column (2), the costs
and savings to certain significant card attributes are calculated. A customer with a
platinum card type will pay about £53 per annum less in servicing the debt of the
average outstanding balance than will a customer with a standard card. In contrast,
a customer with a starter card type pays about £95 per annum more in servicing the
average outstanding balance compared to the standard card type.
Each percentage point increase in the minimum monthly payment is associated
with an additional payment of about £105 per annum on the average outstanding
balance. As previously mentioned, minimum monthly payments are quite small,
and a one percentage point increase would be well above one standard deviation
from the mean. A one standard deviation increase in the minimum monthly payment
(0.034%, or 3.4 basis points) is associated with about a £0.5 per annum increase in
payments on the average outstanding balance. Each additional day on the interest-
free period costs customers about £1 in interest charges on the average outstanding
balance.

6 Experimentation with longer lag periods also yielded results that were not significant.
7 This figure was calculated using data from the British Bankers Association.

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Credit Card Pricing

Customers with cards that use the Amex, MasterCard, and MasterCard/Visa pay-
ment systems would pay about £25, £5, and £14 (respectively) per annum less in
interest payments on the average outstanding balance compared to customers with
cards using the Visa payments system. During the sample period, customers with
cards that had fixed rates would have paid about £52 per annum less on the average
outstanding balance.
Loyalty schemes are used to differentiate products and dampen price competition.
They are therefore costly to customers. Air miles is a well established loyalty-based
scheme, and the premium attached to it is consistent with a switch cost (because
they are irredeemable) but might also reflect customers’ willingness to pay for the
scheme. On the average outstanding balance, air miles costs customers about £26 per
annum. Cash back and discount schemes cost the average customer about £13 and £6,
respectively.
Issuer charity donations are a credit card affinity that is a point of product differ-
entiation that some customers might select and have a willingness to pay for. Issuers
make donations to charity on new purchases and/or when a new account is opened.
A one pence increase in charity donations per £100 spent on new purchases will cost
a customer about £17 per annum in additional interest payments on the average out-
standing balance. A £1 increase in charity donations when an account is opened will
cost about £1.20 in additional interest payments on the average outstanding balance.
In order to induce customers to switch, issuers make introductory offers. Each
month increase in the length of the introductory offer on balance transfers is associ-
ated with payments on the average outstanding balance that are about £4 per annum
higher. Existing customers pay the higher fees on the cards that have the introductory
offer on balance transfers, but these existing customers do not receive the benefit.
We offer three reasons why customers might find themselves paying for this attri-
bute: First, they regard the £4 average as a fairly trivial amount of money to warrant
switching to a card without the introductory offer attribute. Second, the customers
with outstanding balances are unintentional borrowers and do not search for the best
interest rates (Ausubel 1991). Third, customers with outstanding balances find it more
difficult to switch (Calem and Mester 1995; Stango 2000).

6 Conclusions

The results demonstrate a relationship between risk characteristics and credit card
interest rates. Indeed, we find evidence that is consistent with issuers’ using screening
devices to sort customers into different card types. Lower-risk customers who obtain
platinum cards pay lower rates than do higher-risk customers who have been sorted
into starter cards. Customers pay higher interest rates for credit cards with a longer
interest-free period; this might be because it is attractive to higher-risk customers who
are accumulating debt. Issuers require that higher-risk customers make higher min-
imum monthly payments as a percentage of outstanding balances. Therefore, cards
with higher minimum monthly payments are associated with higher prices.
Product differentiation also occurs in order to better meet customer preferences.
The results demonstrate that some customers have a willingness to pay for cash back,

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 K. Amess et al.

discount, air miles, and charity affinity schemes. Whilst it might appear that such
attributes are used to dampen price competition, this is counteracted by issuers’ using
introductory offers on balance transfers to capture market share from rivals. Such
introductory offers are associated with higher card rates, however.
Whilst the paper demonstrates which credit card attributes affect credit card interest
rates, it is important to recognise that the paper is limited in the insights offered due to
the use of a reduced form model. This modelling strategy reflects our data limitations.
Better quality data would allow the estimation of the underlying structural equations
that would explicitly explore the role of supply- and demand-side factors in the credit
card industry.

Acknowledgements We are especially grateful to Lawrence White and two anonymous referees for
providing extensive and detailed comments. We are also grateful to Sourafel Girma, Steve Thompson
and participants at the 6th Annual International Industrial Organization Conference, Washington, DC, for
helpful comments.

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