Because credit card companies and banks must charge the same interest rate on cr

Question

Because credit card companies and banks must charge the same interest rate on credit cards to all borrowers, there is an adverse selection problem with credit cards. How does a credit card company or firm know whether a person will be a high-quality borrower (i.e., one who pays the debts) or a lower-quality borrower (i.e., one who does not pay debts)?

Describe

a. how the restrictions of a single rate leads to an adverse selection problem, and

b.at least two potential means that credit card companies can use to try to lessen this problem.

Explanation / Answer

The following methods can be used by the credit card companies to adjudge their customers and to determine whether they are high-quality or low-quality borrower:

1. By checking their bank statements to know the following:

a. The level of expense that the individual is currently doing

b. The level of savings that the individual is currently doing

c. To check if any case of cheque bounce has happened

d. To check the minimum balance that gets maintained in their account every month

2. Past history of having any credit card can be verified.

3. Individual's legal history needs to be verified

4. The nature of employment needs to be verified.

5. The asset that the individual currently owns must be valued

After analyzing all the above data the credit card company will be able to know about the customer type.

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a. The restriction of single rate leads to adverse selection problem since all cadre of people are given the same level of importance, those who are on the upper scale of earning might not be interested in the same. Since they might use their credit card extensively compared to that of a college student. Hence the single rate system will always lead to adverse selection problem.

_________________________________________________________________________

b. Two potential means by which the credit card companies can try to lessen this problem are by:

1. To set limits for credit card and to supply the customers with the most appropriate one

2. To conduct proper background checks in order to verify the identity of the individual.

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