Regulating Penalty Repricing in the Credit Card Market

Prior to the 2009 Credit Card Accountability, Responsibility, and Disclosure Act (CARD Act), penalty repricing was widely used by lenders as a means to raise interest rates on borrowers with a higher risk of defaulting. We use the CARD Act, which prohibited penalty repricing on credit cards, as a case study to understand the implications of covenant restrictions on lenders and borrowers. In the first part of our paper, we conduct an event study to examine the heterogeneous effects of penalty repricing among revolvers (high-risk borrowers) and transactors (low-risk borrowers). We find that penalty repricing has a larger impact on borrowers who face liquidity constraints in making credit card repayments; after repricing, revolvers' average monthly interest charge increases by 12.81 dollars, which is around 10 times higher than the average increase seen by transactors. In the second part of our paper, we estimate a model with unobserved heterogeneity and dynamic risks in defaulting. In the counterfactual analysis, regulating penalty repricing results in higher initial interest rates (1.75 percentage points), higher average lending (5.01 dollars each month per loan), and higher borrower surplus (9.13 dollars each month per loan) relative to the case where lenders are allowed to penalty reprice.