THE MARKET 35%va as? war-swag CASE? A INSTALMENT CREDIT cmmoasx THEORY AND CASE STUBY lief? ; ' - ' WESES Fm TEE BEGREE @F HE. D. 25 ~ mmem 3mg uneansm WW mm cmanm 3‘9 8 6 HESls W flifi/I/W/WE/M/IMLWI/W/l / . LIBRARY . Michigan Sn. Univcnity This is to certify that the thesis entitled THE MARKET BEHAVIOR OR CONSUMER CASH INSTAIMENT CREDIT GRANTORS: THEORY AND CASE STUDY presented bg Hth Alan Chairnoff has been accepted towards fulfillment I of the requirements for : Ph.D. degree in BUS. Ad. Major professor Date November 29, 1965 0-169 Ayflfifiwfi ABSTRACT THE MARKET BEHAVIOR OF CONSUMER CASH INSTAIMENT CREDIT GRANTORS: THEORY AND CASE STUDY by Hugh Alan Chairnoff The objective of this thesis is to theoretically describe the market behavior of credit grantors in a consumer cash instalment credit market and to examine the appropriateness of the analysis via a case study in Lansing, Michigan. The market is structured according to credit functions. Primary lenders chiefly rely on a wealth constraint to reduce the level of risk and uncertainty. These lenders require access to a consumer's wealth in the event of default. The wealth constraint is an adequate basis for rate discrimination. Contract maturity is related to the durability and resaleability of the collateralized wealth. The secondary lender relies on the income constraint. This lender serves consumers without wealth acceptable to primary lenders and con- sumers whose acceptable wealth already has been collateralized. The secondary lender charges the highest rates in the market. The high level of uncertainty is not conducive to rate discrimination. It is hypothesized that credit grantors, though distinguishable by form of organization, cannot be distinguished by analyzing borrower characteristics. The primary lender relies on the wealth constraint and other loan characteristics. The secondary lender expresses no Preference because there are a large number of sets of characteristics pointing to a probability of acceptable repayment record. An examination Hugh Alan Chairnoff of a limited number of loan application at one commercial bank, two credit unions, and six consumer finance companies indicated that credit grantors did not differentiate with respect to borrowers' income. Also, there was no strong preference for other borrower characteristics by size of income at the three types of credit grantors. The limited examination of loans granted revealed that credit grantors are distinguishable with respect to loan characteristics. The one commercial bank and three credit unions had a much higher preportion of loans to purchase durable goods and real property than the consumer finance companies. About one-half of the loans at the consumer finance companies were for debt consolidation and current expenses; behavior consistent with the theory of the secondary lender. These results are consistent with more elaborate loan samples analyzed elsewhere. The proportion of credit union loans secured by financial assets or automobiles (71 percent of the total) exceed the proportion of loans to purchase durable goods and real property by about 28 percentage PointS. The difference was considerably smaller at the commercial bank. Only about 9 percent of all loans sampled at the consumer finance com- panies were secured by financial assets or automobiles (mostly used}. Contract length only was slightly longer for consumer finance companies than for credit union or commercial bank loans. The minor difference is partially attributable to an above-average level of em- Ployment and residential stability in the Lansing area which permits extension of maturities in order to increase gross revenues. Other loan characteristics reflect the differential influence of the regulatory structures facing each of the credit grantors. Hugh Alan Chairnoff The theory and case study has shown that credit unions and a consumer-oriented commercial bank offer services in both segments of the market. This duplication of services among institutional credit grantors supports the efforts to develop a Uniform Consumer Credit Code. Moreover, the inability of consumer finance companies to compete in the primary lending segment because of a more restrictive regulatory struc- ture supports the effort to eliminate legal discrimination among sup- pliers in the same market. Most financial institutions have evolved into multi-service insti- tutions. The economic impetus to diversification is the more efficient and profitable use of a typically large pool of nonallocative resources. Diversification of market functions is consistent with the maximization of the public welfare. THE MARKET BEHAVIOR or CONSUMER CASH INSTAINENT CREDIT GRANTORS: THEORY AND CASE STUDY By Hugh Alan Chairnoff A THESIS Submitted to Michigan State University in partial fulfillment of the requirements , for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration \ U! L .1111} II. I 11.11 . .n TABLE OF CONTENTS Page LIST OF TABLES O O O O O O O O O O O O 0 O O O O O O O O O O O O 111 Chapter I. PURPOSE AND BACKGROUND OF THE STUDY . . . . . . . . . . 1 II. ELEMENTS 0F DEMAND FOR INSTALMENT CREDIT. . . . . . . . Al III. A THEORY OF THE STRUCTURE OF A CASH INSTALMENT CREDIT Wi—PKET. O O O D O O O O O O O O O l C O O O O O O O O 63 IV. THE MARKET THEORY AND INSTITUTIONAL FUNCTIONS . . . . . 87 V. BORROWER CHARACTERISTICS AND THE THEORY OF THE MARKET STRUCTURE O O O O O O O C O O O I C O O O O O ' O O O 101 VI. LOAN CHARACTERISTICS AND THE THEORY OF THE MARKET S TRUCTURE O O O O O O 0 U C O O O O O O D O 9 O O O O l 26 VII. SWARY AN!) CONCLUSIONS 0 o e e e e e e e e e e e e e e 150 ii LIST OF TABLES Table Page 1-1 Percentage distribution of commercial and industrial loans by size of bank and by distance from bank. . . . 19 1-2 Estimate of size of consumer credit submarkets for the United States consumer credit market . . . . . . . . . 35 11-1 Influence of finance charge on total cost. . . . . . . . 5h II-Z Relationship between the monthly payment and the finance Ch a rg e O O O I O c. O O O O O O O D O O O O O O i O O O 58 II-3 Effect of down payment on.the marginal cost of borrowing 61 Vkl 'Percentage of income groups of consumers having specified assets or debt, 1962 . . . . . . . . . . . . . . . . . 105 Vz2 ‘Mean amount of specified assets or debt held by all families in group, by size of 1962 income. . . . . . . 106 V;3 Distribution of borrowers by income at three consumer lending institutions in Lansing, Michigan, 1964—65 . . 109 VAN Percent of borrowers from three principal types of instalment lending institutions by income classes, lgSOandlgsleeeeeoeeeeeeeeeeeeeoe112 V45 Percentage of borrowers who are males, by income-class and by institution, Lansing, Michigan, 1964-65 . . . . 114 V¥6 Percentage of borrowers who are married, by size of income and by institution, Lansing, Michigan, 1964- 65 O C O O O C O O O O O O O O O O O I O O O O O O O O y...) H 0\ Vs? Percentage of borrowers who are 35 years old or less, by size of income and by institution, Lansing, Eichigan, 1962*.65 . O O I C O C O C . C C C O O O O C O C C O C 0 ll? VL8 Percentage of borrowers with 3 years or less at present residence, by size of income and by institution, Lansing, Michigan, 1965-65 . . . . . . . . . . . . . . 119 VF9 Percentage of borrowers with 3 years or less at present employer, by size of income and by institution, Lansing, Michigan, won-65 . . . . . . . . . . . . . . 121 iii Table Page VLIO Percentage of borrowers reporting liabilities to selected classes of credit grantors, by size of income and by institution, Lansing, Michigan, 1964-65. . . . . . . . . . . . . . . . . . . . . . . 123 WLJ. Percentage distribution of loans by purpose of loans at three consumer lending institutions in Lansing, Michigan, l96h-65. . . . . . . . . . . . . . . . . . 129 VI-2 Percentage distribution of loans by type of collateral at three consumer lending institutions in Lansing, MiChiganglgéa‘65eoeeeeeeeeeeeeeeee' 116 \HQB Percentage distribution of loans by length of contract at three consumer lending institutions in Lansing, Michigan,l96’4—65..o......o...o.... 11"]. VLJ& Percentage distribution of loans by size of loans at three consumer lending institutions in Lansing, MidIigan, 1961+.650 O O O O O O O O O O O O O 0 O O O lu6 iv CHAPTER I PURPOSE AND BACKGROUND OF THE STUDY Purpose of the Study Economic theory suggests that the structure of a market has an influence on the competitive conduct and performance of firms within the market. . . .that a relationship exists between market structure and performance is also a fundamental hypothesis of economic theory.1 The principal elements of market structure are the number of rivals, the size distribution of the firms, the extent of product differentiation, and the conditions of entry. It is the purpose of this study to examine the market Structure and competitive characteristics of the Lansing, Michigan market for 2 consumer cash instalment credit. And inasmuch as a study cf market structure requires a definition of the relevant market and its seg- lBernard Shull and Paul M. Horvitz, "Branch Banking and the Structure of Competition," National Banking Review, Volume 1,. Number 3 (March, 1961+), p. 301. 2With respect to competition and commercial banking, a subject which is not completely outside of the interests of this study, one author has maintained that market performance is insensitive to mar- ket structure. But this does not deny that market structure influ- ences competitive behavior. 0n the contrary, the author goes on to discuss the forms competitive behavior takes under such circumstances. Almarin Phillips, "Competition, Confusion, and Commercial Banking," figurnal of Finance, Volume XIX, Number 1 (March, 1964), PP. 32-46. ments,1 this study also will examine the boundaries of the consumer cash instalment credit market and its segments and their relation to other local Lansing markets for consumer credit. Finally, this study will examine the implications of the resulting market structure and competitive characteristics of the relevant local market for consumer cash instalment credit and its segments for public policy toward and management policy of the participating institutions. Background of the Study Normally, studies of consumer credit, regardless of their origin, begin with a description and analysis of the volume of consumer credit relative to that of other kinds of credit, relative to consumption expenditures in general, and relative to expenditures on consumer durable goods in particular. Because the volume of consumer credit is quite considerable with respect to these measures the study of various facets of consumer credit is justified. But this study shall not burden the reader with such information at this point. Primarily, its avoidance is based on the already strong recognition of the importance of consumer credit apparent in the aca- demic literature. Secondly, perhaps most importantly, th': study of economic behavior need not be based on strictly practical need. The study of the economic behavior of man and the institutions which man has created are worthy of any scholar's intellectual curiosity in —__ 1Market definitions. . ."must be integrated with the other analyti- cal elements of the specific proceeding. A mechanical two-step opera. tion--first defining the market and then examining competition in it“ is not appropriate." Mark S. Massel, Com etition and Mono 1 (Wash. inston, D.C.: The Brookings Institution, 1 2 , pp. 275.7 . ‘11.. . ll. l. l. All their own right. Consequently, this introductory chapter will be devoted to a brief discussion of the development of practical and theoretical interest in the study of consumer credit, a discussion of the relevance of using a local market as the framework for a study of market structure and compe- tition, and the relevance of concentrating on a segment of the consumer credit market . Evolution of Interest in Consumer Credit Academic and public interest in consumer credit has proceeded through a number of stages during this century with each stage focused upon a different aspect of consumer credit. During the earlier part of the 20th century, emphasis was on the public regulation and control of the instututions specializing in the provision of small loans to con- sumers (particularly the small loan companies). The motivation for regulation of credit grantors was the disadvantageous position of the consumer. The borrowers are often ignorant and always in im- mediate need. They are therefore likely to be will- ing to accept whatever terms the lenders may ask. Protection of the consumer from exploitation by credit grantors was thus the primary source of concern in the area of consumer credit in _ lGilbert, Hilborn, and May, snail Loan Lgislation (New York: Russell Sage Foundation, 1925), p. ll. "Since most of the borrowers who approach loan companies or money. lenders are in financial difficulties and in no position to bargain strongly because no other major lending institutions will normally accommodate them, it is considered necessary to 'even out the bargain- ing power' by prescribing maximum lending rates." Repgrt of the Real Commission on Banki and Finance (Ottawa, Canada: The Queen's Printer, 19 , p. 202. the earliest stages of the development of academic and public interest. This source of concern has continued to the present although concern is more frequently directed at strengthening the system of privately operated, publicly regulated institutions in order to further reduce and eventually eliminate the operations of extralegal lenders. Pro-war Stage The second stage of development of interest in the study of consumer credit arose out of the depression of the 1930’s and the expansion of consumer credit which took place during that period. In recommending extensive study of the area of consumer credit, the Ema ploratory Committee on Financial Research of the National Bureau of Economic Research stated their case as follows: Instalment financing of consumer purchases with- stood the strain of the depression so well and showed such relatively small losses throughout the crisis as compared with many other types of credit instruments that banks and other financial agencies, pushed to find outlets fer surplus funds, are now expanding rapidly in this field. This axe pension, moreover, is assuming a competitive form, with respect not only to interest rates and other financial charges, but also to the down payment, the term of loan, the security, and the amount extended in relation to the income of the borrower. As a result, pressure is being brought to bear to relax the strictness of the procedures that tended to safeguard instalment financing during the de- pression. The Committee feels that, in view of its potentialities, this situation deserves careful analysis. At present, it is impossible to decide with any confidence whether these modifications of procedure are justified or whether they constitute introduction of credit standards which are far too lax and which may have serious repercussions. In the present state of knowledge, such judgements cannot be based on data drawn from broad experience; they must be largely expressions of opinion. It is essential, the Committee holds, that an effort 530.1113] . be made to gather all the available data on this type of financing for the purpose of identifying those credit standards which are sound and have stood the test of experience.1 As a result, the National Bureau of Economic Research published ten studies in Consumer Instalment Financing during the late 1930's and early 1940's (see bibliography). Rather than concern with the dis— advantageous position of the consumer-borrower, the focus of these studies was the nature and quality of consumer instalment credit. Postwar Stage The third stage of development is exemplified by the wide-ranging study by the Board of Governors of the Federal Reserve System published in 1957. The preface to this four-part study states the direction of the study as follows: The aim of this investigation has been to bring to- gether information on the significance in the American economy of consumer instalment credit, with the hope of contributing to a wider understanding of its role in the retail distribution of durable goods and its bearing on the problems of economic stability and progress. The investigation necessarily ranges over a broad field, taking account of’both existing and newly developed attitudes. It endeavors to present the many facets of the subject that need to be con- sidered in forming judgements on questions of public policy towards this credit area. Thus the third phase in the study of consumer credit was directed at its effect on economic stability and progress and'the question of *- 1Ebcploratory Committee on Financial Research, A Program of Finan- cial Research, Volume 1 (New York: National Bureau of Economic Re... search, 1937, p- 29. 2 Board of Governors of the Federal Reserve System, Consumer Instalment Credit: Part I Volume I Growth and Im rt Washington, D. 0.: United States Government Printing Office, 1957 , preface. public policy in controling the use of this form of credit. Current Stage At present, interest in the study of consumer credit has taken two directions. First, the National Bureau of Economic Research has renewed its studies of consumer instalment credit. Present projects are concerned with the analysis of the rate structure in automobile financing, investigation of the economic aspects of the regulatory policies of states toward consumer credit, the effects of credit use upon the management of consumer finances, an investigation of the flow of funds from their sources through financial markets to their ultimate use by consumers, and the impact of consumer indebtedness upon unemployed 1 families. An already published study of the costs of providing con- sumer credit was based on the following rationale: The striking growth of consumer credit has stimu- lated widespread interest in the costs of providing consumer credit among institutional sources. The difficulties of cost allocations and the lack of uniform cost accounting procedures have long delayed the acquisition of cost data for consumer credit operations among the major types of credit insti- tutions . This work is part of a broad study of consumer credit which is designed to assess its role in the functioning of the economy of the United .‘States.:3 1Foreword by Robert P. Shay in Paul F. Smith, Consumer Credit Costs 1 1+ --1 (New York: National Bureau of Economic Research, 19 4 . p. xix. 2 M49 Pv Mic 3%, pe m1 0 Another aspect of the present concern with respect to consumer credit has to do with renewed interest in the regulation of the com- mercial lenders that provide credit services to consumers. The origin and basis for the regulation of consumer credit enterprises is being restudied in the light of develOpments -which have occurred since the concept of regulated and supervised commercial lenders was accepted as the general solution to the problems of preventing evils in this area. The release of the subcommittee of the National Conference of Countie- sioners on Uniform State Laws' {haecial Cormnittee on Retail Instalment Sales, Consumer Credit, and Small Loans and Usury states the impetus behind their investigation of the applicability of a uniform consumer credit code as follows: The Commissioners on Gniform State Laws have under- taken their consumer credit project at the request of the Council of State Governments. Substantial impetus to the project has been given by the decisions of the Supreme Court of Nebraska holding that State's retail installment sales legislation to be unconsti- tutional. FUrther impetus has been provided by the bills entitled "Truth in Lending," introduced in the Congress by Senator Douglas and others. They deal with one aspect of consumer credit problems: the disclosure of the cost of credit at the inception of each transaction. In attaining their objective, however, the subcommittee plans to study substantially all aspects of consumer credit trade practices. Elrthermore, the need for further study of the regulatory concepts in the consumer credit field has been well-expressed as follows: M 1 Gilbert, Hilborn, and May, 0 .cit., p. 11. 2Release of the National Conference of Commissioners on Uniform State Laws, 1964. we are not suggesting that credit institutions, arrangements offered, customers serviced or problems arising in the consumer credit market have become such that a homogeneity within the market exists which requires casting aside all regulatory treatment of differential participants and of different consumer credit arrangements. Our studies to date do not provide us with the information or experience to make any such judge- ments now. What we are suggesting, however, is that the time has come in the development of consumer credit as an institution which requires us to undertake an integrated study of the whole body of legal prescriptions which are applied to consumer credit activities and services. we need an across-the—board review of existing legis- lation to determine its nature and scape, to identify areas where similarity of regulation exists and where it does not. We should then reexamine the aims and concepts embodied in such legislation originally and determine, on the basis of’a definitive study of the consumer credit market as it exists today, if and in what respects any of these original ideas have become obsolete and in what ways our concepts or objectives need to be revised. The recommendation of the Royal Commission on. Banking and Finance in Canada reflects a regulatory concept different from that characterized by present-day legislation. Their recommendation was as follows: As noted in the previous chapter, we believe that all cash lenders--including the banking institutions ~~should be subject to uniform regulation, and we think it appropriate that supervision of the amended legislation be transferred to the Inspector General 0f BankS.2 Thus, academic and public interest in consumer credit has developed in a number of ways, each of which is of individual importance. L 1Confidential source. 382Report of the Royal Commission on Banking and Finance, op.cit., Po 2. Further Interest But interest in the study of consumer credit does not end with public consideration of the specific problem areas. Rather, interest also has developed as the result of a more general interest in the functioning of the nation's financial markets with the objective of gaining further insight into their importance and their patterns of behavior. In 1937, the National Bureau of Economic Research surveyed the state of knowledge of the nation's capital markets. Their report noted: A comprehensive survey of the financial structure as a whole is urgently needed to provide back- ground for the analysis of financial problems and to give perspective to proposals for changes in the financial structure. . . This survey must not be limited to central banks and commercial banks where our information is now relatively most complete. It must include the activities of savings banks, investment banks, insurance companies, finance companies and underwriting houses. It must be sufficiently comprehensive, fimthemore, to show not only the structure and mnctions of these various types of financial organizations taken individually, but also their relative importance and interdependence. Without the basic financial survey. . . it is impossible to come to any well-considered opinion concefnirg many of the most pressing problems of today. This report of the National Bureau was followed by other such reports in 19116, 1954, and 1964. Although the 1964 report of the National Bureau referred to the capital markets in general and made specific recommendations for research in particular sectors of the capital lExploratory Committee on Financial Research, op, cit“ pp. 23.240 10 market,1 the applicability of the report to consumer credit is equally valid. The National Bureau's report, for example, called for a critical examination of the impact of legal and regulatory influences on the market structure and competitive characteristics of particular sectors of the capital market.2 The Report also pointed out the need to know more about "the the degree of market segmentation due to legal factors or customary ’1. practices, about differential risk attitudes and preferences."’ Kore specifically, the report of the fiational Bureau stated: Particular issues which should be examined are the criteria that might be used in assessing the optimum degree of specialization among financial institutions, the extent to which our institutional structure falls short of the optimum, and whether that structure has on balance tended to'improve or deteriorate in the period under review. facility of borrowers in seeking alternative sources of funds, about Fi“ally. the National Bureau's report pointed out that the rather extensive literature concerning the market structure and competitive characteristics of the commercial banking industry is not duplicated in other areas of the capital market.5 Thus, the recommendations for research in the general area of the financial markets have developed from one of comprehensive surveys 1National Bureau of Economic Research, "Research in the Capital I'Iarkets," Journal of Finance, m supplement (Kay. 1964)- 2 . 92-51.” p. 5- 3%;: p. 6. “.Iam... p. 8. 5923.34: P~ 8- ll of the financial structure to one of intensive analysis of the patterns of behavior and interrelationships. The current objective is to judge the effectiveness of the existing structure and offer recommendations for change to improve its effectiveness. Supplementary Statement of the Purpose of the study The preceding discussion ably illustrates the many facets with which a study of competition and market structure in a consumer credit market can concern itself. These facets can be summarized as follows: 1) institutional behavior in relation to its environment, 2) intra- and inter-institutional relationships, 3) influence of the legal and regulatory structure - on institutional behavior, D 1;) nature of alternative sources of funds and their degree of availability, 5) degree of financial specialization of institutions and market performance, 6) relevant definitions of consumer credit markets and submarkets. The purpose of this study, in order to refine further the earlier state- ment of purpose, is to describe and analyze these facets of consuzrzcr credit in a specific geographical environment. The goal of the analysis is to formulate conclusions and recommendations dealing with the criteria of evaluation of market performance, the extent of economic and non- economic differences in institutional behavior, and the degree to Which economic and non-economic factors aid or disturb efficient market functioning . 12 Validity of the Scope of This Study The discussion to this point has focused on the various facets of the study of consumer credit. The discussion concluded with a summary of those facets which are relevant to this study. But two questions remain unresolved : 1) Is it conceptually valid to limit the study to a specific geographical location, and 2) Is it conceptually valid to limit the study to one segment of the consumer credit market? The remainder of this chapter is devoted to demonstrating that these two limitations of the study are valid in that they permit the examina- tion of market behavior under a unique set of conditions which are known and relevant to all credit grantors operating within these limits. Spatial Dimensions of a Consumer Credit Market Markets in General then we speak of markets we are Speaking of a set of common circumstances that permit us to analyze behavior and events in a meaningful fashion: Alfred Marshall expresses it thusly: '-.-Jhen demand and supply are spoken of in relation to one another, it is of course necessary that {he markets to which they refer should be the same. If markets do have a spatial dimension, then we are implicitly reCOg- nizing that demand and supply conditions for any given product do vary over space. In the extreme case, the spatial dimension may be so overwhelming that demand and supply conditions in a Specific geographical ‘_. j— M 1 Alfred Marshall, Elements of Indust , Volume I of the Elements W (London: Macmillan and Co., Ltd., 1920), p. 181;, 13 location are, to a large extent, independent of the demand and supply conditions for the identical product in any other geographical location. Edward Chamberlain provides this example of the substantial importance of spatial dimension: Thus the cement industry in the United States with 162 mills operated by 75 companies (1938), the five largest of which produced under 1&0 per cent of the total, would appear by this measure to be almost purely competitive, whereas the element of spatial monopoly is actually so great as to make it one of the most striking cases of monopolistic competition. In general, the greater the suitability of the product for grading and portability, the greater is the breadth of the market for that product. Marshall illustrates this point with a brief discussiOn of the narrow- ness of the markets for bricks and the broadness of the market for well- known securities, both corporate and governmental. The condition of suitability for grading will not be discussed at this point inasmuch as it involves the question of product differenti- ation, a question which will be dealt with at some length in demonstra- ting the validity of focusing upon a segment of the consumer credit. market and at greater length in analyzing institutional differences in the cash instalment loan segment of the consumer credit market. The question of portability, however, is worthy of inquiry at this point because it does provide an excellent vehicle for discussing the nature of spatial dimensions of markets. A‘ lEdward H. Chamberlain, Towards a More Genejrgl Theory of Value (New York: Oxford University Press, 1957), p. 78. 2 Marshall, 0 .cit., p. 186. 3Ib1do’ pp. 187-1880 114 The portability of the product can be such that, ceteris paribus, the effective cost of purchase is a function of distance. As Marshall recognized : Thus the more nearly perfect a market is, the stronger is the tendency for the same price to be paid fer the same thing at the same time in all parts of the market: but of course if the market is large, allowance must be made for the expense of delivering the goods to different purchasers; each of when must be supposed to pay in addition to the market price a special charge on account of delivery. A readily apparent implication of the existence of transportation charges is that the closer the supplier to the purchaser, the higher the price he may charge so long as he does not exceed the effective cost to the purchaser of acquiring the product from a more distant lender. It then follows that a group of suppliers in proximity to a group of purchasers face a finite demand curve. The ability of the mnxfliers to exert influence on price, however, is tempered by the proximity of other groups of suppliers. Thus there is an upper limit tn the discretion of a group of local suppliers in establishing price zmlicy. In short, each supplier and each local group of suppliers are nwnopolistic competitors.2 The upper limit, it is to be noted, is determined by the amount of transportation expense a purchaser must incur in order to acquire the product from the next closest group of mnnfliers, given the market price under purely competitive conditions. In a discrete world, suppliers of a product at one given point posses lIbid., p. 185. 2Chamberlain, o .cit., p. a7, 15 a monopoly so long as the price to purchasers does not exceed the total - cost of importing the identical product from another given point, given the amount of tariffs or other costs of importation. This simple model of the influence of Spatial dimensions caused by the degree of unportability make it clear that "market" behavior must be carefully defined in many cases in order to reach appropriate con- clusions regarding the extent and types of competition which exist among suppliers. The existence of a finite demand curve rather than an infinite demand curve requires a different concept of what is meant by the "market." Although the degree of isolation of a group of suppliers may vary with the area of space over which they extend,1 the principle is apparent: in a discrete world, the possibility that spatial differ- entiation of markets for the identical product can‘influence the behavior of suppliers is a situation that must be dealt with carefully. In a non-discrete world, the role of spatial differentiation is not quite so apparent. The continuity of the population does not permit any kind of precise definition of the spatial barriers of any market. In Marshall's words: In applying economic reasonings in practice, it is often difficult to ascertain how far movements of supply and demand in erg one place are influ- enced by those in another. Chamberlain attempts to describe the problem as follows: In trying to get this type of problem clearly in mind a good first approximation is to think of an abstract "model" in which a population of buyers :Marshall, op.cit., p. 188. Ibid“ p. 185. I’l‘i’l‘l .ii' - \Ill‘lz‘. I11 l. is distributed fairly uniformly over a spatial area, and the sellers of a product-homogeneous, except for the spatial aspects to be considered, and offered initially by all at the same price-- distribute themselves about the area in an attempt to make sales by appealing solely to the conven- ience of as many buyers as possible. The result would evidently be a fairly uniform distribution of sellers over the same spatial area, each one with a "market" consisting of those buyers located nearest to his place of business.1 In the non-discrete case, the outer limits of the "Inarket " of each supplier quite probably overlaps, to some degree, the outer limits of another supplier's "market." EXpanding this concept to the analysis of geographical markets in densely populated areas, the conclusion holds. One can clearly visualize a Lansing, Michigan market for con- sumer credit vis-a-vis the Detroit, Michigan market for consumer credit some 75 miles away. But can one readily conceive of a Lansing market for consumer credit vis-a-vis a Mason, Charlotte, Grand Ledge, or Holt market for consumer credit knowing that these political subdivisions are within a 25 mile radius of Lansing? Certainly, the outer limits of these markets intersect to a considerable extent. In other words, certain suppliers within a political subdivision are in a position to supply the product to buyers of another political subdivision that is 2 nearby. whether the contiguity of markets in the non-discrete case affects the behavior of suppliers in both markets is also worthy of inquiry, It would be a first step to increasing our understanding of 1Chamberlain, o .cit., pp. 46-47. 2 In reality, political subdivisions have no necessary relation to market relevancy. 17 market behavior and the diffusion of innovations, attitudes, habits, and customs. And if this analysis can link the entire consumer credit market, then we have substantiated and existing belief (already partly documentable) that investigating and analyzing national trends and relationships can be valid for certain types of policy formulation. Within limits, then, the analysis of the Lansing, Michigan market for consumer instalment credit is valid. Conceptually, at least, there can be barriers which spatially differentiate markets for the identical product. The next section will examine the factors which create these barriers in a financial market, keeping in mind that more direct forms of product differentiation have not been discussed as yet. Theory of Commercial Loan Marketsl Commercial loan markets do differ from the general conception of markets which were the focus of the preceding section. The major dif- ference is that financial products are perfectly differentiable to the extent that each borrower possesses a set of characteristics which are unique to him. Operationally, however, individuals are grouped into classes in order that credit grantors can efficiently function in this market.2 It is also to be noted that each loan arrangement may be unique with regard to the various provisions which it usually contains. 1See Franklin R. Edwards, Concentration and Com etition in Comercial Banking: A Statistical Study {Research Report No. 26: Boston; Federal Reserve Bank of Boston, 1960/), pp. 8-11. 2Lawrence L. Werboff and Marvin E. Rozen, W Competition Among Financial Institutions (Research Study Four, Private Financial Institutions: Englewood Cliffs, :fw Jersey; Prentice-Hall, 1533;, po 237- A! vII I I'll: 1|.I . 18 However, for the purpose of this discussion, it is convenient to assume that loan arrangements are initially homogeneous. The analysis will then be able to indicate that spatial dimensions of a market may require credit grantors to alter loan arrangements as well as alter the credit grantors' examination of borrower characteristics. In a perfectly competitive commercial loan market, if we assume that costs are not a function of distance between lender and borrower, it is clear that any businessman would be able to obtain a loan from any bank without regard to spatial considerations and assuming that the businessman does qualify for credit. Too, commercial loan portfolios of commercial banks, the primary institution in this market, would not be especially weighted with loans made in any specific geographical area. However, it would not be difficult to demonstrate that commercial loan portfolios are not evenly distributed with respect to geographical area. On the contrary, an overwhelming proportion of commercial loans, if not the entire portfolio, consist of borrowers from the local com- munity and surrounding areas. Stating it in another way, "transporta- tion" costs are not zero, but are significantly different from zero. Part of a recent study by the House Committee on Banking and Currency is applicable here. The data are sunnnarized in Table 1-1, The Percent- age Distribution of Commercial and Industrial Loans by Size of Bank and by Distance from the Bank. The data supports the contention that com. mercial loan portfolios are not distributed evenly with respect to geographical area. The greater the distance from the bank, the smaller the proportion of the commercial loan portfolio devoted to loans at 19 Table 1-1. Percentage «:3:‘_s-::ibur;ion of comercial and imiustrial loans ‘23; size 0“ bar? and by éiStancs iron: Foal/4:3 Within Outside Home Within 50 to Over 100 Deposit Size Hometown Base but With- 100 Miles of Niles from (in millions) or City in 50 Miles Home Base Home Base Over $100 77 12.5 3 8.5 $50 to $100 71 22 a 3 $25 to $50 81 16.5 1.5 1.6 $10 to $25 76 21 2 1.1; Under $10 70.5 28 l 0.9 zfikmmighted average over the following four types of banking systems: 1. city unit 2. city branch 3. other unit 11,. other branch Source: Subcommittee on Domestic Finance, Committee on Banking and Currency, House of Representatives, A Study of Selected Banking Services by Bank Size Structure and Location (Washington, D.C.: Government Printing Office, 1931+), pp. 38-39. ’- 20 that distance. This conclusion is not only true of the smaller-sized banks but generally is true for the larger-sized banks as well. The transportation costs of a commercial loan can be classified as to those incurred by the lender and those incurred by the borrower. The case of spatial differentiation of financial markets differs some- what from the case of commodity markets in that suppliers in the com- modity markets need not necessarily bear the costs of transportation. But in the financial markets this is not so. A commercial lender does incur costs which are the result of negotiating and lending to distant applicants. Firstly, the credit grantor probably experiences an in- creased cost in investigating the applicant in order to determine his creditworthiness: the degree of uncertainty and the class of risk. Although the cost of investigation will vary with the size of the applicant, investigation costs will vary also with distance insofar as the credit grantor must seek information from sources outside the range of his normal investigatory channels. Thus, all other things equal, the loan to a distant applicant will be less profitable than an identi- cal loan to a local applicant of the same risk class and with a similar degree of uncertainty. The difficulty in obtaining information and the limits to the credit grantor's entrepreneurial capacity tend to increase the degree of uncertainty and risk of a distant applicant. That is, there are limits to the credit grantor's ability to determine the proper class of risk of the applicant inasmuch as he is unacquainted with the firm, its managers, the spatial dimensions of its markets, and the economic environment of its market. Most probably, the lender would prefer to 21 overstate the degree of risk and uncertainty. Thus, all other things equal, the cost of lending to a distant applicant would be greater than that of lending to a local applicant of the same size and operating in an enviroment which is more familiar to the lender. If the credit grantor is a commercial bank, a third kind of "trans- portation" cost may arise. In deteming its investment policy a com- mercial bank takes into consideration the stability of its deposits and reserves. The stability of these items is related to offsetting drains of reserves and deposits among banks. The more localized are the bank's borrowers and depositors and the more localized are the other banks' borrowers and depositors, the greater is the tendency for reserve and deposit drains for any one bank to be offset by similar drains at other banks. Hence, the greater the stability of reserve and deposit accounts. In dealing with a distant borrower, however, the greater is the prob- ability that the commercial bank will not experience an offsetting drain of reserve and deposit balances. Thus, investment policy will be af- fected in terms of its maximum profitability to the extent that the bank must maintain a higher proportion of primary and secondary reserves because the bank is doing business with distant firms. It would not be consistent with profit maximization for the bank not to charge a higher rate for funds extended to distant borrowers under these circumstances. The distant borrower also incurs costs which serve to limit the distance he is willing to travel in order to negotiate a loan. To the borrower, however, these costs may be largely reflected in the loan arrangements and the degree of financial flexibility of its financial operations. For example, because of the expected loss of reserves and ——‘.’.— _'_ 22 deposits, a commercial bank may insist upon a higher average or minimum deposit balance. Or, the bank may reduce the line of credit or the amount of the loan in an attempt to compensate for the imprecise mea- surement of the borrower's risk class. Finally, the distance between borrower and lender may limit access to the other financial services of the lender such as advice and counsel and other forms of financing. The inconvenience in availing himself of these other services tends to restrict his solicitation of these services. Thus, the borrower from a distant lender tends to have a higher effective cost of borrowed funds than a borrower from a local lender at the same explicit rate of interest. Under otherwise purely competi- tive conditions, the existence of these costs implies that loans from distant lenders may be inconsistent with the business firm's assumed profit maximizing behavior . Convenience When the consumer rather than the business firm is the borrower, the convenience of the borrower plays a more important role. Even under perfectly competitive conditions, obtaining funds requires an expenditure of time. Furthermore, the expenditure of time implies a cost to the borrower which raises the effective cost of the loan. To be consistent with the maximization of utility, the borrower should seek to minimize the time spent in obtaining a loan, all other things equal. The cost of the expenditure of time is an opportunity cost. Ex- panding time in obtaining a loan requires the consumer to reduce either his working time or his leisure time. The cost of time (labor time or leisure time) is the amount of income which may have been earned by the borrower had he worked during that time. Consequently, the more time spent in obtaining a loan, the higher the effective cost of the loan. To the extent that distance does involve an expenditure of time, a consumer-borrower would do well to minimize this time consistent with minimizing the effective cost of the borrowed funds. Under conditions of pure competition, a loan from a local credit grantor would have an effective cost which is less than that of obtaining the loan from a distant credit grantor. But, local credit grantors now possess a mo- nopoly which permits some degree of price influence. But because they are surrounded by potential competitors, there is an upper limit to the ability of these local credit grantors to control the price of their services. The closer credit grantors are to each other, the smaller is the ability of any one credit grantor to exercise price control. A group of credit grantors, however, can exercise price control limited only by the proximity of another group of credit grantors whose solici- tation by consumers would require more time and hence a greater cost. Summary The preceding discussion has established an a priori basis for supposing that markets are spatially differentiated. These are costs Which are a function of distance. It then follows that focusing on a Specific spatial market will be useful for the study of market structure and competition. This conceptual approach to studying markets permits us to examine the nature of the cross-elasticities among spatial markets ,———.__- _—‘ 24 for the same product and to analyze its nature and implications for the patterns of behavior of financial institutions. Authoritative Opinion General recognition of the geographical limits to financial mar- kets, particularly those markets involving consumers and small busi- nesses, has been recognized by students of intra- and inter-institu- tional competition. This section will present but a sample of the statements of these recognized experts. In a recent study of mortgage and savings markets in California, the authors indicated the nature of part of their analysis as follows: . . .the analysis proceeds to local market struc- ture within the state, which in most respects are more relevant than California totals and which vary widely from area to area.:L A monograph on the consumer credit industry prepared for the Commission on Money and Credit stated: Each individual market, however, has more or less distinct geographic limits since the area served by any one office is restricted to the immediately adjacent territory, which can be conveniently reach- ed by available transportation. Convenience is recognized as an important competitive factor in providing consumer credit service. Recent studies of small mortgage markets (areas with population of less than 100,000) stated the hypothesis as follows: lLeo Grebler and Eugene Brigham, Savin s and Mort a 6 Markets in California (Pasadena: California Savings and Loan League, 1934;, p. 10. National Consumer Finance Association, 11221 Consumer finance mm (A Monograph Prepared for the Commission on Money and Credit: Ei'tghmood Cliffs, N.J.; Prentice-Hall, Inc., 1962), p. 24. 25 Since lending institutions operate with signifi- cantly different sets of attitudes toward F.H.A. and V.A. lending, knowledge of the relative im- portance of the major institutions in a market can be used to predict the amount of F.H.A. and V.A. lending that will be done in the market.)- A.recent paper on the factors involved in analyzing local competition has this to say: Only the smallest business borrowers, in company with other small borrowers-~consumer instalment borrowers, most farm borrowers, and many, if not most, residential real estate mortgage borrowers --are limited in their choice of banks, largely to local banks. Whether this limitation is or is not significant in a given local situation however, can only be revealed by a study of relevant quali- tative and quantitative aspects of that situation, such as: asset-allocation preferences, of the bankers Operating in the local market; the presence or absence, and the intensity, if present, of non- bank competition in the various credit-granting product lines; and the number a size distribution of the locally competing banks. In discussing the relevant market for banking products, the authors of a case study of banking competition make the following point: However, if it is one's purpose to describe and analyze structural change, it is useful to note that for a sizable share of its total banking output, a particular banking office faces most of its competition from those other offices which are "accessible" to a "significant portion" of its actual or potential customers. This would seem especially true in an area in which banking opera— 3 tings are primarily retail in nature, as in Nassau. ‘— lGillies and Curtis, "A Note on the Small Mortgage market," :kmmnal of Finance, volume (September, 1959), p. 411. 2Clifton H. Kreps, Jr., "Characteristics of Local Banking Comps- tition," Banking and Monetary Studies, ed. Deane Carson (Hemewood, Illinois: Richard D. Irwin, Inc., 1963). p. 321+. 3David C. Matter and Deane Carson, "Bank Entry and The Public Interest: A Case Study," National Bankigg Review, Volume 1 (June, 1961*), PP0 483-4850 In discussing the degree of competition which exists between various consumer cash lending institutions, a noted consumer credit analyst stated: The degree to which competition exists between the various types of cash lending institutions differs from place to place and from time to time.:L Commenting on the Supreme Court's decision in the Philadelphia National Bank merger case, one economist said: Particularly questionable is the Court's use of aggregate data for the banking industry as a whole, as evidence of the degree of concentra- tion which prevails. Such data throw no light on the concentration which exists in individual markets, and these are the only relevant figures for assessing the competitive effects of concen- tration.2 §ubmarkets of the Consumer Qedit Market The previous section considered the role of space in differenti- ating among markets for the same product or family of products. This section considers the role of product and supplier characteristics in differentiating among submarkets within a spatially defined market. The objective of this section is to present a basis for studying a single submarket in order to gain further insight into the functioning of that submarket, the functioning of the entire market, and the rela- tion of the submarket under study to other submarkets in the spatially defined system of sul'markets. -—.‘ 1Ernst A. Bauer, "The Nature of Competition in Consumer Credit," Tenth Annual National Consumer Credit Conference (Columbus: April 21, 1958 ), reprint. 2Victor Abramson, "Private Competition and Public Regulation, " n Banki Review, Volume I (September, 1963), p. 104. 2'? Assumptions and Implications of Arbitrary market Classification It is implicit in any discussion of market differentiation that the cross-elasticities of demand among submarkets is quite low. A low ruice-volume sensitivity among submarkets indicates a high degree of unrelatedness among the factors determining the conditions of supply and demand in each submarket. The analysis of competition and market structure, then, is more relevant with respect to any submarket to the extent that the cross-elasticity'of’demand does indicate that some economic variables can be segregated from factors pertinent to the market in general. That is, the recognition of submarkets implies that each submarket has characteristics which are unique to it. The analysis of market structure and competition within a sub- merket also will be more relevant to the extent that common character- istics among submarkets are accounted for. Further, the analysis of competition within a submarket is significant only to the extent that the characteristics which are unique to that submarket are significant. It should be realized that the attempt to classiiy'a market into segments may not be theoretically precise and hence not practically precise. There must be some arbitrary element in drawing the boundary, and all products must be regarded as a continuous serief in more or less close rivalry with each other. 1h fact, the attempt to classify markets is a complex task. Another complication must be recognized. Differs ences in consumers' income and in geographical fl . lJoan Robinson, Economics of In erfect com etition (London: I'iamnillan and Co., Ltd., 1934 , p. 11 . 28 location divide an industry or market, as defined above, into overlapping markets. These differ- ences complicate the analysis of market structure by adding other factors which need to be examined, and which may further narrow the actual market area. Yet they do not invalidate the basic dis- tinction between products which can, and those which cannot serve a defined purpose.- We have dealt conceptually with the problem of spatial differentiation. The problem of consumers' income and preferences (demand) will be defer- red until a later chapter. For the present, our purpose is to deal conceptually with the segmentation of the consumer credit market within its spatially defined limits. Product and Supplier Characteristics in General The measurement of cross-elasticities of demand has not developed to the point where it provides meaningful results. Consequently, al- though the assmnption of a low cross-elasticity of demand is at the heart of market segmentation, less technical means must be used to construct submarkets. The most frequent method used is to list all the general character- istics of the product or products and the characteristics of suppliers in order to determine which of these general characteristics provides a basis for differentiating among products and markets. The following list is representative of the general characteristics of the product or PPOducts and their suppliers: lLawrence Abbott, Quality and Competition (New York: Columbia University Press, 1955), P. 34. ‘ Zrafark S. I-“assel, Compjtition and Monopply (Washington, D.C.: Tne Brookings Institution, 1962), Po 215- ' 1) 2) 3) 4) 5) 6) 7) 29 physical characteristics of products, and uses of the product or products, attractiveness of the product or products to buyers, influence of sellers' costs, relative prices of the products, unit of measurement of the product or products, 1 the stages of marketing,‘ idflch of these characteristics provides a basis for partitioning a market depends on the particular situation, including the objectives of the researcher. No doubt examples of market segmentation based on 1' tions of one I 1) 2) 3) u) 5) 6) 7) each of these characteristics come readily to the reader's mind. The n objective of partitioning a market may be the analysis of the implica- or more of the following factors: measurement of concentration, price control, taxation, subsidies, antitrust, evaluation of market performance, other policies affecting business behavior. The criteria which are employed in partitioning the consumer credit nmrket can best be based on the purpose of the analysis of’market structure and competition. The criteria that are employed will be 1 Ibid., pp. 241-257. 2 Ibid. , p. 254. 30 best developed within the context of the consumer credit market rather than a more or less a priori discussion of the criteria. Consumer Credit Submarkets - Maturities Firstly, the consumer credit market may be subdivided according to maturity: short-term, intermediate-term, and long-term. Long-term consumer credit consists almost entirely of real estate mortgage credit:L In statistics of the national income, investment in residen- tial housing is reported as gross private domestic investment. As a result, rental income from omer-occupied housing must be imputed. In addition, the large size of mortgage credit contracts and a market organization substantially different from that of other forms of con- sumer credit dictate their exclusion from the generally accepted con- cept of a consumer credit market. It should be pointed out that the use of mortgage credit (senior and junior) for consumption purposes has risen sharply in recent years and poses a significant alternative to the more accepted forms of fi- nancing consumption expenditures. However, for the present purpose, long-term or real estate mortgage credit will be considered outside 2 the definition of the consumer credit market. "As the term has come to be generally used, consumer credit covers credit extended to consumers through regular business channels, exclusive of real estate mortgage credit which is almost entirely long- term." "Revision of Consumer Credit Statistics," Federal Reserve Bulletin, Volume 39 (April, 1953), p. 336. 2"Although the consumer credit concept logically includes real estate mortgage credit on owner-occupied houses, this type of credit traditionally has been omitted." 33251;," p. 739. 31 Consumer Credit Submarkets - Instalment vs. I-Ioninstalment Credit Secondly, the consumer credit market can be subdivided into instal- . ment credit and noninstalment credit. Instalment credit includes all consumer credit held by financial institutions and retail dealers which is scheduled to be repaid in two or more instalments.LL Noninstalment credit, on the other hand, consists of single-payment loans, charge accounts, and service credit.2 With the exception of single-payment loans, charge accounts and service credit are convenient forms of credit that permit households to economize on their cash balances. Toe, the average size of this form of credit is quite small and mostly arises out of the purchase of non-major consumer goods. As a result, charge accounts and service credit are not repaid out of future earnings which is the case with consumer instalment credit, but they are repaid from the liquid asset holdings of the household. That is, convenience consumer credit is very similar to the working capital loans of business firms. Furthermore, charge accounts and service credit are held by retail stores and’ service enterprises rather than financial institu- tions. Although financial institutions may be the ul+imate source of financing, we can clearly distinguish between these forms of credit and those which are more clearly initiated by the financial institu- tions themselves. Charge account and convenience credit are used as a competitive device in the merchandising of goods and services. Conse- 1 Ibid. , p. 341. 2 Ibid , 32 quently, its nature, expansion, and use is very closely allied to the promotion of retail sales rather than to the independent promotion of consumer financing. Single-payment loans for consumption purposes are granted by financial institutions as well as pawn brokers. These loans may be unsecured but probably are more often secured by share accounts, time or savings accounts or marketable securities such as stocks and bonds. This study will arbitrarily include single-payment loans in the cash lending segment of the consumer credit market although this type of loan is not always integrated into an institution's major consumer credit policies. In addition, the inclusion of this type of loan will permit us to consider its implications with respect to the larger volume of cash instalment credit. Consumer Credit Submarkets - Instalment Creditl Consumer instalment credit may be subdivided into instalment sales credit and cash credit. Financial institutions are the ultimate source of instalment sales credit. But the credit transaction itself is only a part of the total transaction which also includes the sale of merchan- dise. Too, instalment sales transactions are regulated independently of the regulation of cash loans. Although institutions may participate in both submarkets, their policies are affected by the existence of these separate regulations. 1For a somewhat similar discussion see National Consumer Finance Association, The Consumer Finance Industry (A Monograph Prepared for the Commission on Money and Credit: Englewood Cliffs, N.J.; Prentice- Hall. Inc., 1962), pp. 23027. 33 Retail merchants are an integral part of the market for instalment sales credit. Competitive practices of financial institutions revolve around these merchants. Contact between the consumer and the financial institution does not occur until the contract between the financial institution and the dealer has been completed. Consequently, policies with respect to instalment sales credit and cash credit must be differ- ent to some degree. Another difference arises from the use to which the instalment credit is put. Instalment sales credit is limited, by definition, to the purchase of consumer durable goods. Cash credit, on the other hand, has no limits to its uses. In this sense, the market for cash credit is much broader than that of instalment sales credit.1 The broadness of the market for cash credit requires a different policy inasmuch as security, maturity, and the rate of charge are oftentimes unrelated to the purchase of durable goods that possess a satisfactory degree of collateral value. Consequently, distinguishing between instalment sales credit and cash credit is valid from the point of view of the uses of the credit and the nature of the credit decision. Lastly, the institutions which participate in the markets for instalment sales credit and cash credit may differ as much as they ‘— !_ 1The author recognizes that this concept can be quite arbitrary. The difficulty of determining the true purpose of the borrowed funds has been expressed as follows: "Applicants lacking reserve resources may require cash for one of several needs, so that if funds were not borrowed for one use they would probably be borrowed for another. " Ralph A. Young, Personal Finance Companies and Their Credit Pracg._c_es (Studies in Consumer Instalment Financing: New York; National Bureau 0‘1” Economic Research, 19140), p. 61. 34 overlap. Credit unions and consumer finance companies, for example, are not permitted to offer inducements to dealers in order to acquire instalment sales paper. In fact, these institutions must deal directly with the consumer. Retail merchants typically do not retain ownership of the instalment sales paper they originate. Commercial banks do advertise direct auto loans as well as purchase instalment sales paper In short, the institutions involved in each segment Further- through dealers . of the consumer instalment credit market are not identical. more, institutions which do participate in both segments of the instal- ment credit market do not necessarily pursue identical policies with respect to these segments. Consequently, there is a basis for con- sidering cash lending and instalment sales credit as submarkets of the consumer instalment credit market. Outline of Consumer Credit Submarkets The segments of the consumer credit market can be outlined as follows : Consumer Credit Market (Short- and Intermediate-Term) I. Submarkets for Noninstalment Credit A. Charge Account Credit B. Single Payment Loans '11. S‘ubnarkets for Instalment Credit A. Submarket for Instalment Sales Credit B. Submarket for Cash Instalment Loans Table 1-2 presents the dollar amount of consumer credit outstanding in each of the subuarkets outlined above for the entire nation. The MF- 35 Table 1-2. Estimate of size of consumer credit submarkets for the finited States consumer credit market Cash Instalment Loans Commercial banks - automobile - personal loans Sales finance companies - personal *Other financial institutions - total Tbtal Instalment Sales Credit Commercial banks - automobile — other goods Sales finance companies - automobile - other goods Retail outlets Total **Repair and Modernization Loans Commercial banks Sales finance companies Total Sipgle-Payment Loans commercial banks Other financial institutions Total —__ Source: End of $ #9003 4,877 1.751‘ 1138§2 § 22,422 $ 7.2h6 3.123 8,228 3,383 § 28,222 $ 2,361 1 $ 5.0“? 01% §L_Jb£fi§2 Federal Reserve Bulletin (January, 1965), pp. 160-161. ‘ Includes repair and modernization.loans of $870 million at the end of 1963 and $890 million at the end of June, 196%. ** Shown separately because of the difficulty in determining the pro- portion of purchased paper and the proportion of direct loans. 36 table differs from the Federal Reserve presentation inasmuch as that presentation is based on the use of the flmds rather than the type of transaction. Table 1-2 makes it abundantly clear that the segmentation of the consumer credit market is not theoretically precise. But it also indicates the relative importance of each of the submarkets given the geographical dimensions of the market (in this case the United States). As a result, the study of the cash lending segment of the instalment credit submarket does furnish a valid market for the analysis of compe- tition and market structure. In addition, the relation of the cash lending segment to the instalment sales credit segment can be meaning- mlly considered and evaluated. Although the largest proportion of consumer instalment credit is in the form of instalment sales credit, the difference between the proportion of instalment sales credit and the proportion of cash instal- ment credit is narrow; instalment sales credit constitutes approximately- 56.1% of the total, cash instalment credit constitutes approximately 43.9% of the total. When single-payment loans are added to cash instal- ment loans, direct loans are almost equal to instalment sales credit. Repair and modernization loans are classified separately because of the difficulty in determining the proportion of these loans which are indirectly acquired and those which are directly acquired. What- ever the true proportions, however, the size of the market for home repair and modernization loans is small enough not to materially affect the proportions of cash instalment and instalment sales credit. '- fifl—WF 37 Sumary The classification of the consumer credit market into submarkets and, more particularly, the classification of the consumer instalment credit market into submarkets is achnittedly tenuous inasmuch as the classification was based almost exclusively on noneconomic considera- tions; that is, legal, structural, and regulatory differences. It is, a major objective of this study, however, to consider the relationships among these submarkets on the basis of economic considerations. The purpose of this section was to present to the reader some basis for arbitrarily classifying the consumer instalment credit market so that the boundaries of the succeeding analysis are clearly understood. The consideration of the entire consumer credit market will be more meaning- no if we explicitly change our assumptions as to the nature of the market. Although this approach may appear to be unrealistic at first it does have the virtue of simplicity and lucidity. In addition, economic differences and similarities may be more clearly emphasized and their nature more fully understood. Applicability of a Case Study of Competitive Behavior In the preceding two sections it was argued on theoretical grounds that the study of competitive behavior must be conducted, in effect, on a case-by-case basis.l It is then pertinent to inquire as to the mean- ingfulness of a case study with respect to the more practical considera- tions with which such a study is often surrounded. It would not be -——_.¥ 1This is equivalent to the comments of the experts on pages 24-26. Footnote 3 on page 25 is a case study of bank competition in Nassau County, New York. 38 inappropriate at this point to consider this question; for this study is based on the implicit assumption that there are concepts and rela- tionships to be recognized that have general applicability when cor- rectly qualified. The theoretical appropriateness of the case study implicitly rests on the idea that aggregative analysis (macroeconomic analysis) must abstract from variations among the individual components of the analysis. That is, aggregative analysis develops average relationships among variables which may be sufficient for the purposes in mind but do not hold universally in any fixed manner. But more importantly,‘ the justification for the case-method of study must admit that aggrega- tive analysis must conceal microeconomic’ effects that may severely limit the applicability of the conclusions of such an analysis. In any event, it is the burden of thelcaseImethod approach to indicate the degree to which more aggregative forms of analysis must be qualified in order to produce operational implications. Perhaps the burden of demonstrating the applicability of aggregative analysis should lie with the aggregative analysis. In fact, the costs of the case-study approach are not benefited by the economies of mass analysis with the result that the case-method must explain the degree to which aggrega. tive analysis can be justifiably employed if the case-study approach's overall contribution is to be acceptable. Of course, the case-study approach to economic research can be appropriate on grounds other than its potential value as a check on the. validity of aggregative analysis. In an economy in which decisions are made by a rather large number of independent units, a microscopic -—.—o—‘_ 0"— 39 examination of a small group of independent units (such as those within a particular geographical submarket) possesses an inherent consistency and meaning that aggregative analysis cannot approach; for a micro- scopic examination permits attention to be directed to a greater number of parameters and details which aggregative analysis cannot reasonably take into consideration.1 And inasmuch as decision-making based on macroeconomic relationships can only be considered by the largest of economic organizations, the utility of a more microeconomic approach yet remains. The proper framework for decision-making by a unit bank in Lansing, Michigan with respect to its investment in automobile paper, for example, very reasonably cannot consist of the analysis of consumer buying intentions based on data collected without regard to geographical locality. The uncertainties which would attach to the analysis and the consequent decision-making process by the bank would almost certainly undermine the efficacy of this type of decision-making process. In short, the case-method approach is a valid research methodology that explicitly recognizes that the decision-making proces- ses of perhaps all but the largest economic organizations is conditioned by the parameters of their immediate sphere of activity; and it is precisely within this immediate sphere of activity that knowledge of variations from macroeconomic relationships could be more important than the relationships themselves. There is another facet to the practical aspects of the usefulness of the case-method approach in analyzing competitive behavior. Regu- k l The advent of the computer age and its vast potentialities does limit the appropriateness of this remark. lation of financial institutions has traditionally been the responsi- bility of state governments and the federal government. Will the analysis of behavior within a specific locality produce anything of value for the purposes of improving regulation? Although the problem of regional differences within the state still exists, the case method of research should be expected to uncover basic concepts and relation- ships that are of value in appraising the effectiveness of state as well as federal regulation of financial institutions. The case-method approach can be employed to analyze the extent of variations from presumed behavioral patterns, subsequently contributing to minimizing the variations in behavior that are attributable to regulation. Thus, from the more practical point of view, the case-method approach to research into competitive behavior has value in evaluating the impact of regulation. In summary, the case-method approach to studying competitive behavior is valid for a number of reasons. These reasons are suffici- ently important from a number of viewpoints to proceed with the case study with the further expectation that some mndamental concepts and relationships can be extrapolated from the case analysis that will be applicable to geographically-defined markets in general. CHAPTER II ELEMENTS OF THE DEMAND FOR INSTAIMENT CREDIT This chapter will discuss the theoretical aspects of the demand for consumer instalment credit. Our objective is to point out aspects of this demand, to which credit grantors may react. More specifically, the discussion of the elements of the demand for instalment credit will permit us to examine the concept of the demand implied from the observ- able behavior of institutional lenders. Investment Theory The analysis of the demand for instalment credit can take two paths. One path is concerned with the analysis of the purchase of consumer durable goods which provide monetary rewards in the form of costs avoided.1 Traditional investment theory is quite applicable to this form of consumer investment for it places great reliance upon the rate of interest as a regulator of the demand for "productive" assets. The rational consumer, in this case, would compare the yield (rate of return) on the proposed asset with the market rate of interest in order to determine the efficacy of the prospective purchase. The market rate of interest is the relevant marginal cost of capital only under conditions of a perfect capital market; that is, when the borrowing rate and the lending rate are the same. Under *— v.— T. 1For a more technical discussion than that which follows, the reader is referred to P. Thomas Juster and Robert P. Shay, Consumer Sensitivit to Finance Rates: An Em irical and Anal ical Investi ation New York: National Bureau of Economic Research, 1 1&1 a“ 42 imperfect capital market conditions, the borrowing rate is higher than the lending rate. Consequently, the relevant marginal cost of capital is the borrowing rate.1 Application to Other Consumer Goods The traditional theory of investment has been applied infrequently to the analysis of consumer expenditures in general.2 The problem in applying the theory lies with the presence of nonmonetary factors which are an integral part of the decision-making process. These nonmonetary factors are the utilities or satisfactions which the con- sumer receives from an object of consumption. The inability to quantify utility prohibits the comparison of the rate of return with the marginal cost of capital in order to determine whether such a purchase would contribute to the optimal use of the consumer's income, present and future. It has been noted already that certain types of consumer durable goods may be analyzed with the traditional apparatus. These consumer goods are mainly cost-saving devices in that they allow the consumer to avoid the expenditure of funds on alternative means of acquiring the services which are desired. The purchase of a home laundromat, for example, produces revenue for the consumer by eliminating the need 1 The nature of an imperfect consumer capital market will be more mlly discussed at the end of this chapter. 2In the following articles two authors have worked at expanding the number of consumer goods which can be analyzed in terms of tradi- tional investment theory: J .V. Poapst and W.R. Waters, ”Individual Investment: Canadian Experience," Journal of Finance, Volume XVIII (December, 1963), pp. 647-666, and "Rates of Return on Consumer Dur- ables," Journal of Finance, Volume XIX (December, 196%, pp. 673.678, g 43 to have his clothes cleaned at a laundry service. The cash outflow in the present time is the present value of the future instalmant payments to be made to the lender. This outflow is then compared to the time series'of cost savings which are expected to occur over the useful life of the durable good. But even in the case of cost-saving consumer goods there are non- monetary factors which have importance to consumers to varying degrees. To return to the laundromat example, its purchase not only involves the avoidance of expenditures on laundry service, it also involves the factor of convenience. The disutility of traveling to and from the laundry service is avoided; the disutility of having to perform the mechanical processes connected with the home laundromat is also in- volved. In short, a cost-saving durable good is a time-saving and time-consuming device as well. The Time Rate of Preference The problem of the analysis of consumer expenditures is complicated also by another factor. Consumers are assumed to express a preference for present consumption over future consumption. A consumer, for example, may be willing to give up $1.00 worth of present consumption for $1.25 worth of future consumption or vice versa. Unless we are aware of the consumer's rate of time preference, it is impossible to determine the optimum distribution of consumption between present and future, given the consumer's present income and his expected future 1 incmme. This fact is one of the keys to understanding the theoretical and actual behavior of consumers toward the use of instalment credit. ‘a lCost-saving devices are, of course, an exception. lgpgct of Instalment Credit To prOperly focus the discussion of the impact of instalment credit with respect to consumer behavior, a number of assumptions will be helpful. Firstly, let us assume that the consumer's present and future income is known with perfect certainty» Secondly, the consumer always prefers more consumption to less consumption. As a corollary, the consumer would prefer a given amount of consumption now to that same amount of consumption in the future (this really fellows from the concept of the time rate of preference). The consumer borrows today in order to increase his present con- sumption. In return, he "mortgages" a part of his future income in order to repay the principal amount of the loan plus interest. Given his future income, the consumer must reduce future consumption in order to repay the loan plus interest.1 Note that the absolute amount of consumption which must be given.up in the future, assuming a constant level of prices, is greater than the absolute amount of consumption which is obtained through borrowing in the present; the interest paid on the loan accounting for this difference. The relevant question to ask is: How can we theoretically justify an absolute increase in con- sumption today at the cost of a greater absolute decrease in consumption in the future? Conceptually, the analysis can.be made within the framework of traditional investment theory with the exception that .— 1This discussion assumes that savings are a form of consumption that constitutes a fixed proportion of the consumer's income, present and future. Further, accumulated savings are assumed not to be sub- Stitutable for income with respect to loan repayments. -' "'"—.s(' 45 the yield on the object-of consumption will be substituted by the consumer' s time rate of preference. The consumer's goal is to maximize the present value of his con- sumption, given that he incurs a cost in postponing consumption.1 If we discount the amount of future consumption which is foregone in order to repay the loan plus interest we can compare this with the value of the increase in present consumption permitted through borrowing. If the net difference is positive, the consumer is behaving in a theo- retically correct manner in borrowing to finance the purchase, for he has increased the present value of his consumption over the period the funds are to be repaid. But in order to achieve a better understanding of the relationship between the cost of instalment credit and the rate which is used to discount future consumption foregone, a different approach must be used. The quantity of future consumption foregone is presumably dis- counted by the consumer's rate of time preference; the rate which establishes the relationship between a given absolute amount of present consumption and a certain greater absolute amount of future consumption toward which the consumer is indifferent. This rate of time preference is determined by the shape of the consumer's indifference curve be- tween present and future consumption and it is assumed to decrease with successive increments of present consumption over fixture con- sumPtion. If the rate of time preference is greater than the cost of the instalment loan, the consumer will be increasing the present value ~ lIt 13 assumed for the purposes of this analysis that the amount to be borrowed is equal to the purchase price of the consumer good or service to be financed. d‘"-'_f “ of his total consmnption over the period of the loan by borrowing the funds necessary to increase present consumption. In terms of the process outlined above, a rate of time preference greater than the cost of the instalment credit results in a net increase in the present value of consumption. Tb give an example, suppose a consumer is indifferent between $1.00 worth of consumption today and $1.25 worth of consumption one year from now. For the consumer to borrow $1.00 to increase his cur- rent consumption, he should not be willing to pay more than $1.2 5 at the end of one year (principal plus interest). The effective annual rate of charge on the borrowed funds cannot exceed 2 5% per annum if the consumer's behavior is to be considered rational. The rate of time preference is the maximum rate of sacrifice of future consumption which the consumer can incur in order to increase the present value of his total consumption fer the entire period.1 Under perfect capital market conditions, a consumer could borrow any amount of funds he desires. He will do so as long as the marginal borrowing rate (the market rate of interest) does not exceed the marginal rate of time preference. Under imperfect capital market conditions, the consumer faces an upward sloping supply curve of consumer credit. Successive borrowings only can be obtained at successively higher rates of interest. The consumer will continue to borrow until the marginal borrowing rate exceeds the marginal rate of time preference. Nete that in either case the consumer's marginal rate of time preference is the Ultimate regulator of his demand for instalment credit. It is a 1It is also the minimum yield. ' ~— 'I- -— ‘I 47 substitute for the rate of return or yield concept which is employed in traditional investment theory and to the analysis of consumer demand for goods which permit the avoidance of other costs. Note, too, that in either case the analysis is consistent with traditional investment theory; the appropriate cost of capital is the market rate of interest in the case of the perfect capital market and the marginal cost of capital is the marginal borrowing rate in the case of the imperfect capital market. Institutional Borrowing Constraints The concept of the imperfect capital is not limited to the fact of a rising supply of credit which each demander must face. Suppliers of credit may limit the maximum amount of debt any borrower may carry at any one point in time. Such a constraint has the effect of making the supply of credit available to a borrower perfectly inelastic at some total amount of credit. For some consumers, for example, this perfectly inelastic portion of the supply of credit may intersect the demand for credit at a point below that which would occur if a rising supply curve of credit were the only characteristic of an imperfect capital market. A number of constraints employed by the credit grantor readily come to mind. Perhaps of greatest significance is the lender's concept 01‘ the meadmzm relationship of loan repayments to the borrower's ex. Pected future income. The objective of such a constraint is to avoid Placirg the consumer-borrower in a position in which the repayment of the loan can be made only with undue strain. The margin of safety implied in such a constraint is perhaps of more importance to the lender with respect to the consumer-borrower than with respect to the businessman-borrower, for the problem of consumer bankruptcy has reached major proportions in recent years.1 The wealth position of the consumer is another constraint upon the consumer's capacity to accept credit. The greater the wealth position of the borrower, given his income, the greater will be the amount of debt institutional lenders will grant. The definition of consumer wealth, however, is not always similar to the traditional meaning of wealth. Credit grantors view the consumer's wealth posi- tion with respect to the protection such wealth will provide for their loans. This protection takes the form of claims against the wealth in case of default. Not all forms of wealth will be acceptable as col- lateral for a loan. Moreover, various kinds of wealth have varying degrees of acceptability to credit grantors as collateral for their loans. Liquid assets, for example, will be acceptable to all credit grantors for the simple reason that this type of asset can be readily converted to cash at a very small cost in case of default. An auto; mobile, on the other hand, may be of limited collateral value depending on the age and condition of the vehicle. is a result, loans secured by automobiles will bear some relation to the estimated market value of the vehicle less cost of disposal.‘2 In general, consumers will be h —w 1This statement is qualified by factors which are to be discussed on the following pages. 2 This relationship between the value of the collateral and the loan can be thought of as ranging from zero to one depending on the nature and condition of the asset and the extent of the secondary market through which the asset must be disposed in case of default. “9 permitted to accept more debt the greater is their wealth which would be acceptable as collateral to credit grantors, ceteris paribus. Rationed and Unrationed Consumers The constraints placed upon consumers in acquiring debt which result in a rising supply schedule of instalment credit are the heart of a recently published theory concerning the reaction of consumers to changes in the finance rate. The authors concluded: Consumers are not, as frequently though, wholly unre- sponsive to the finance rates charged on instalment credit contracts. Rather, they are unresponsive to rates when subject to credit rationing, as that term is used here. Since the majority of consumers probably fall into the rationed category, there will be little rate response observable in the population as a whole under existing conditions.1 Consumers whose marginal borrowing cost is in excess of going rates of primary lenders are here called rationed. Defined in another way, rationed consumers are those whose average outstanding debt to primary lenders is less than the amount they would prefer, given the rates charged, and unrationed consumers are those2whose actual and preferred debt levels are the same. ' Unrationed consumers, then, possess the income and particularly the wealth necessary to obtain their credit needs such that the market need not ration them.3 Their need for credit is limited by their demand for high-cost durable goods. As Juster and Shay postulate, consumers' sensitivity to changes in the finance charge is a function of the need for instalment credit, the demand for durable goods, and the ¥ 1Juster and Shay, op.cit., p.2. 2%- ’ Po 14. 3Rationing in the sense of the slope of the supply of credit and in the sense of an absolute limit to the amount of debt they are per. mitted to assume. —-—- u———‘ 50 store of acceptable collateral.1 Rationed consumers, on the other hand, are faced with institutional constraints upon their borrowing capacity. They must seek increments to their liabilities, after a point, from secondary lenders (credit grantors who do not require as much or no collateral) at higher rates of charge; and their search is not always successful. Although the decision to borrow from secondary lenders may be consistent with the maximization of the present value of the rationed consumer's consump- tion, their desire for credit beyond that which will be granted by primary lenders leads them to a position in which they cannot afford to be sensitive with respect to the rate of charge on borrowed funds. Other Elements of the Demand for Instalment Credit The following pages discuss a number of aspects of the demand for instalment credit which are believed to have a significant influence on this demand. More to the point, these other elements are generally thought to be responsible for the fact that the demand for instalment credit is relatively inelastic with respect to the finance charge. The previous discussion has offered an explanation for the fact that the demand for instalment credit is relatively inelastic for a certain class of consumer. The extension of this discussion is essential to a better understanding of the market behavior of institutional lenders in the market for consumer cash instalment credit. lJuster and Shay, op.cit., p. 1. It may be pointed out that this also implies a relatively lower marginal rate of time preference than that of rationed consumers. Substitutes for Ins talment gradit Current consumption can be increased by means other than the use of instalment credit: namely, the use of past or current savings.l Until very recently, opinion.of academic economists and consumer credit officers of financial institutions was that savings are not an effec- tive substitute fer instalment credit. There is a plausible reason for believing, however, that these assets would not be used to any great extent fer the purchase of goods otherwise obtain- able on credit. Those who incur instalment debt in spite of the fact that they possess liquid assets 'must have strong reasons for not using these assets for the purchase of goods. Instalment credit is expensive. The annual rate which the consumer has to pay on his average unpaid balance is never much below 12 percent and in most cases is substantially higher than the yield of saving deposits, bonds and most other salable assets. Hence, it would be very irrational for a man to incur a debt on which he has to pay perhaps 15 percent or even more instead of selling a bond on which he earns perhaps 5 percent or even less, and it would be still more irrational to incur such a debt in order to protect saving deposits or cash reserves on which the yield is next to nothing--unless he is considering other factors than immediate cost.2 These factors other than immediate cost which the consumer is likely to consider can be summarized in the Keynesian terms speculative motive and precautionary'motive.3 The speculative motive leads consumers to __ 1This discussion will assume that other sources of debt capital are not available. That is, loans from friends, relatives, etc. and single- payment loans from financial institutions do not represent effective substitutes for instalment credit. ZGottfried Haberler, Consumer Instalment Credit and Economic Fluctuations (New York: National Bureau of Economic Research, 1552), IN RE. The transaction motive is omitted here inasmuch as transactions balances are more directly affected by the use of convenience credit rather than the use of'short- or intermediate-term consumer instalment credit. .—_v ‘__"-_$ 52 maintain a store of liquid.assets with which to take advantage of future opportunities for profit. Consequently, any reduction in the store of liquid assets maintained for speculative purposes involves a cost in terms of future profit foregone. Liquid balances maintained for pre- cautionary purposes do not have an explicit cost. Rather the cost of reducing precautionary balances must be expressed in terms of the utility or satisfaction foregone by reducing the precautionary balances. Thus, although interest charges on instalment credit may be high, the use of instalment credit may be a rational decision if the marginal loss of utility and future profit through a reduction of liquid balances is greater than the marginal cost of the instalment credit. A recent National Bureau study revealed that liquid assets (past savings) are a more effective substitute fer the use of instalment credit for certain classes of consumers. Consumers whose store of liquid assets are high in relation to their credit needs and consumers whose credit needs are limited because their demand fer durable goods is limited (unrationed consumers).1 In these cases, the utility and Opportunity for profit which is foregone by reducing the store of liquid assets to finance the purchase of a consumer good are negligible, on the margin, with respect to the total store of liquid assets. Consequently, liquid assets are a more significant alternative to the use of instalment credit for these classes of consumers. At the other extreme, consumers who are unable to build a store of liquid assets have no alternative to the use of instalment credit. A lJuster and Shay, og.cit., p. 10. 53 It is to be concluded that the store of liquid assets can be a substi- tute for instalment credit only to an imperfect degree. The degree of substitutability of liquid assets for instalment credit is to be thought of as a range primarily determined by the credit needs of the consumer, ins demand fer durable goods, and the ability of the consumer to build a store of liquid assets. The demand for instalment credit is generally believed to be relatively more inelastic with respect to the finance charge the greater the proportion of the consumer population that are rationed by institutional lenders because this proportion of the population, for one thing, lacks a sufficient store of liquid assets. Relative Cost o§:;nstalment Credit Alfred Marshall's theory of derived demand is partially appro- priate for the analysis of the demand for instalment credit.l Let us assume that instalment credit is a factor of production in the sense that it is one of the inputs necessary to provide the consumer with the ability to purchase the goods and services he desires. Given this assumption, two of Marshall's principles of derived demand can be used to demonstrate that the demand for instalment credit is relatively inelastic with respect to the finance charge. Marshall's third principle of derived demand is: the derived demand for any factor will be more inelastic the smaller the fraction of total cost that goes to the factor in question.2 Table II-I 1For a full discussion of the theory of derived demand see ‘— Milton Friedman, Price Theory (Chicago: Aldine Publishing Company, 1962), Chapter 7. Ibid., p. 153. .owucno eonmnwm one ca commune op vacancy spas vmoo aspen mo mpflOfipmec on» omHm ma madman maxed flzm.m RH©.N RwQ.N Rmm.m mmw.m wam.m - vwou Hence cw owcwsu omsecconom mowoma fiomoma Ro&.HN woo.om $00.03 mom.:m vmoo Heaps op omnmso coaccfim . .mo owvmm ca emzmgo cwepCeoacm xmw.oa $00.0N Roo.nm mmm.mm $00.0m $00.00H emacno occcafim ca owccno cwcucooncm mmma. mmma. coma. Hmoa. omwo. memo. Homo. Hpmoo Hence op owndnu oocmcfim mo capmm oam.aa oma.aa oma.ae owa.aa omo.aa ooo.ae omo.aa ewoo assoc Sm m owe a oma m 8H m om w oo mo 3 owned ooaooE Ocaama ooaaac oooaflw oooafiw oooada ooo.aa oooaflw coco canchda Ho ocean a o m e m . N. H Jnenesz :moa unoo H.300 no owhcso conga.“ Mo 92.85% .HIHH 3”me 55 demonstrates the effect of’a constant dollar increase in the finance charge on the total cost of purchasing a $1,000 consumer durable good vdth instalment credit. The data in the table assumes no downpayment is necessary and that the term of the loan is identical for each case (one year). For all loans, the percentage increase in the finance charge produced a less than proportional increase in the ratio of the finance charge to total cost. Mbreover, for a given percentage in- crease in the ratio of the finance charge to total cost, there was a less than proportional percentage increase in total cost. In short, the total cost of purchasing a consumer good with instalment credit is inelastic with respect to the finance charge, given the price of the durable good. Even though the finance charge was increased by 100%,.for example, total cost increased by less than 3%. If the rela- tionship between changes in the finance charge and changes in total cost were plotted on a graph, the result would be a rectangular hyperbola, a curvilinear relationship that implies inelasticity throughout. Essentiality of Instalment Credit Another of marshall's principles is concerned with the essentiality of an input to the demand for that input. Marshall demonstrated that the demand fer a factor of production is more inelastic the greater is the essentiality cf the factor. Thus, if we continue to assume instal- ment credit to be an input, the greater its essentiality to the con- sumer, the more inelastic is the demand fer instalment credit with r68pect to the finance charge- we have already noted that many consumers do not possess a store of liquid assets which is sufficient to be an effective substitute for con- sumer instalment credit. Juster and Shay pointed out in their study that liquid assets are still an imperfect substitute fer instalment credit for consumers who do possess a sufficient store of liquid assets. Taken together, these two cases of the degree of essentiality of instalment credit lead to the conclusion that liquid assets and instal- ment credit are but imperfect substitutes. Consequently, consumer insensitivity to changes in the finance charge are to be expected; the degree of sensitivity being greater for the unrationed consumer than for the rationed consumer.2 Lack of knowledge Whenever and wherever the subject of the costs of instalment credit is discussed, the inability of the consumer to make sense out of the section of the contract dealing with the finance charge is often raised. There have been monographs,3 legislative proposals,4 and large-scale studies and considerations of this problem and its effects on consumer behavior.5 This study will not attempt to review or add to the sub- 1The authors' computed finance charge elasticity ranged from a low of -.005 to a high of -.299. Juster and Shay, op.cit., p. 29. 2It should be pointed out that the essentiality argument is very similar to the substitution argument. The concepts which were employed in both sections, however, warranted this differentiation. 3Robertw. Johnson, Methods of Stati Consumer Finance Char as (New Ybrk: Columbia University Press, 1957). ”Senator Douglas' series of Truth-in-Lending bills. 5Juster and Shay, op,cit. .—-!__ 57 stantial literature on the subject. But the existence of difficulties and confusion for the consumer in determining the true rate of charge on an instalment loan contract is mentioned frequently as another reason why the demand for consumer instalment credit is relatively inelastic with respect to the finance charge.l Effect of Monthly Payments It is frequently argued that consumers are insensitive to changes in the rate of finance charge because such changes do not materially affect the monthly payment, given the length of the contract. Of course, Juster and Shay assert that only rationed consumers would be insensitive to the finance rate and sensitive to the monthly payment. This kind of behavior is necessary because these consumers are not permitted the desired level of debt from primary lenders. Lowering the monthly payments permits them to acquire more debt inasmuch as the institutional constraint on a borrower's capacity to borrow bears some relation to the ratio of the monthly payment to expected future income. Table 11-2 describes the relationship between changes in the monthly payment and changes in the finance charge for a twelve month, twenty-four month, and thirtyasix month loan. Nets that the percentage change in the annual finance charge is greater than the percentage change in the monthly payment regardless of contract length. Further, lThe Juster and Shay study discovered that "the majority of re- 5pondents had little awareness of the finance rates they had actually paid on their past instalment credit transactions: about 7 percent of the sample gave reasonably accurate estimates of the effective annual finance rates paid; 11 percent estimated the approximate add-on or dis- count rate equivalent paid; the remaining 82 percent were unable to give rate estimates of reasonable accuracy." Juster and Shay, op.cit., P. 3. as? and sees ease amen. some tats figs em - ass ewes mews awom dawns mews 893%”. 55a in .. mama was... was...“ anew amen ass 3.350 553 NH - "wedged 35.82 a.“ 095.8 omfisoonom 8.3% 2.3.” mmdi much.“ wmdma Rama.” wméma 9.33:8 canoe on u 3&3 $.03 3.3% $43 3.9% $.91.” 543$ poenunoo 5:08 am .. 3.8% 93$ 36% Rag 8.0mm Rama, 8.3% 39350 55a NH - ceased aaficoz Sm a 02 a one a 02 a om a 8 a on a 03.26 8:22 352 80.3,. 804% 82$ 084a 80;; 89% 08.3 38 @323 do 82a a e m a m. N H £852 $3 omaeno 005.8” 9.3 one flashed hgwnos 2.3 90033 eacmcoflmaom .muHH 03$ 59 the percentage changes in the monthly payment are positively related to changes in the length of the contract. Thus, although the monthly payment is relatively insensitive to changes in the annual finance charge, the longer the contract length the more sensitive is the monthly payment to changes in the annual finance charge. Inasmuch as academic and business opinion believe that the monthly payment is an important variable with respect to the demand for instalment credit, the insensitivity of the monthly payment to changes in the annual fi- nance charge is another reason for thinking that the demand for instal- ment credit is relatively inelastic with respect to the finance charge.1 length of the Contract Table II-2 also permits us to examine the relationship between the monthly payment and the length of the instalment credit contract. Fbr example, an increase in the finance charge of 100% would increase the monthly payment of a twelve month contract by $2.50. Yet if the length of the contract was extended to twentyafour months at the same time the finance charge was increased, the monthly payment would de- crease by almost $h0. Notice, too, that given the finance charge, the percentage change in the monthly payment is less than proportional to the percentage change in the length of the instalment credit contract. 1"Third, the analysis suggests that the size of the monthly instal- ment payment plays a considerable role in the determination of instal- ment sales credit demand, which confirms prevailing opinion." Avram Kisselgoff, Factors Affectin the Demand For Consumer Instalment Sales Credit (New York: National Bureau of Economic Research, 1952;, p. 53. Juster and Shay computed demand elasticities using a "payments" model. The elasticities range from .000 to -.034. Juster and Shay, 02.cit., p. 29, It has been concluded that consumers, more specifically rationed con- sumers, are more sensitive to changes in the length of the contract be- cause the changes in the length of the contract more materially affect the monthly payment than do changes in the finance charge. It should be noted also that changes in the finance charge combined with changes in the length of the contract tend to make the effect of changes in the finance charge rather immaterial when compared to the effect caused by the change in the length of the contract. Effect of Down Payment The down payment on the purchase of a durable good is believed tO’ be a major determinant of the demand for instalment credit. The reason is obvious: the down payment requirement has the effect of requiring the consumer to use his current income or store of liquid assets to acquire the durable good. Thus, Federal Reserve regulation of instal- ment credit terms included regulation of the required down payment in order to reduce the demand for instalment credit. The down payment requirement forces the consumer to incur an addi- tional cost of using credit. The cost is in terms of future profit Opportunities foregone and/or the disutility of giving up a portion of his precautionary balances. Note, too, that a down payment requirement eliminates those consumers from the demand for instalment credit who do not possess liquid assets with which to make the down payment. Requiring a down payment increases the marginal cost of borrowing.1 _ 1"If loan size is smaller than purchase price or if contract maturity 15 less than the service life of the asset, the market finance charge does not cover the total cost of time and risk associated with ownership of the asset." Juster and Shay, op.cit., p. 10. all»! 1'“ .ll‘l. .1 .1") I ll ullfl! ull‘\¢1‘ I in II r'll‘lhlllll I‘h.'lulll\ll ll" If“ I {I Table 11-3 shows the effects of a change in the rate of down payment. The data assume the following: 1) purchase price - $1,000 2) borrowing rate — 8% add-on 3) opportunity cost of liquid assets - 6% per annum 4) length of contract - twelve months Table 11-3. Effect of downpayment on marginal cost of borrowing Down Payment Marginal Cost of Borrowing None lh.8% 10% 16.0% 20% 17.5% 30% 19.5% Finally, the effective annual marginal borrowing cost is computed from the constant ratio formula.1 The implications of these results are worth pursuing. As was demonstrated by Regulation W, increases in the required down payment reduced the demand for instalment credit and thus the demand for consumer 1The formula for the constant ratio method of computing the effective annual interest cost is 2 x m x D . P n + 1 'This formula will not produce the true annual interest cost inasmuch as the Opportunity cost occurs at the end of the year rather than regularly throughout the year. However, the fbrmula does produce a reasonable picture of the effect of the down payment requirement. 62 durable goods at the margin. In terms of Juster and Shay's rationed and unrationed consumers, liquid assets are not an effective substitute fbr instalment credit. But Table 11-3 also demonstrates that, with respect to downpayment provisions, liquid assets and instalment credit are complements. The effect of downpayment provisions is to increase the marginal cost of capital. This is true for rationed as well as unrationed consumers. Thus, increases in the required downpayment not only reduce the demand for instalment credit at the margin, it causes a downward shift in the demand for instalment credit.l The economics of complementary factors tells us that an increase in the demand for one of the complements (an increase in the required downpayment can be considered to be an upward shift in demand) causes a downward shift in the demand for the other complementary factor (in this case, the demand for instalment credit). .. I’ll.) ill]. \lll.‘ lulllllul lull -: mi ll“. CHAPTER III A THEORY OF THE STRUCTURE OF A CASH INSTALMENT LOAN MARKET Much of the literature of consumer credit has been devoted to the description of the operating behavior of institutional lenders.l What these discussions have lacked, however, is a model of market structure which can be employed to explain the behavior of the institutions who are being observed. It is the objective of this chapter to offer a theory of the market structure which attempts to explain the behavior of institutional lenders. A Perfect Consumer Credit Market If the market for short- and intermediate-term consumer credit were perfect, any consumer could acquire as much debt capital as he desired at the market rate of interest with but one limitation. The limitation that would be placed upon any consumer's capacity to acquire debt would be the expected value of the consumer's future income available for debt 1The following references offer a detailed description of the operating practices of institutional credit grantors: The American Bankers Association, Thg_g2mmgggi§l_§g§§;§g_;gg§§tgy (A Monograph Prepared for the Commission on Money and Credit: Englewood Cliffs, N.J.; Prentice—Hall, Inc., 1961), Chapter V. The National Consumer Finance Association, The Consumer Finance Industgy (A Monograph Pre- pared for the Commission on Money and Credit: Englewood Cliffs; Prentice-Hall, Inc., 1962). Theodore A. Anderson, "Market Practices in the Consumer Lending Industry," Consumer Instalment Credit, volume 1, Part 2 (washington, D.C.: Board of Governors of the Federal Reserve SYStem, 1957). John M. Chapman, Commercial Banks and Consumer Instal- ment Credit (New York: National Bureau of Economic Research, 19405. Ralph A. Young, Personal Finance Com nies and Their Credit Practices (New York: National Bureau of Economic Research, 19h05. 63 IIII. It I. ‘l Ill-IIIIJ‘I I'll. - . '_. 6h repayment capitalized at a rate which would reflect the risk category in which credit grantors have placed him.1 On this basis, consumers would face a perfectly elastic supply curve of short- and intermediate- term consumer credit up to the maximum permitted by the suppliers of credit. At the maximum amount of debt, the supply curve would become perfectly inelastic.2 In short, the structure of the consumer credit market would be one of atomistic competition: each borrower and lender would take the price of the loan as given; institutional constraints are limited and applied uniformly by all institutional lenders. Characteristics of an Imperfect Market Abstractly, each loan to a consumer is perfectly differentiable from any other loan to any other consumer or to the same consumer at two different points in time. Every loan represents the result of analysis, of the needs and capabilities of the borrower, and a program designed personally for him. Thus, technically every consumer credit transaction is unique since there are not two borrowers or purchasers whose needs and capa- bilities are identical .3 lFuture income available for debt repayment is a synonymn for cash flow. In practice, the credit grantor uses the consumer's cash flow as the basis for determining the maximum amount of funds he will lend (the income constraint). The income constraint under discussion here is to be considered identical to the cash flow of the consumer. 2This is not to argue, however, that the consumer's cost of capital is constant. Chapter II pointed out that a down payment requirement, for example, increases the marginal cost of capital. The opportunity cost of unpledged financial assets also affects the consumer's cost of capital. 3The Consumer Finance Industry, op.cit., p. 27. 111111 J 65 From a practical point of View, perfect differentiation of consumers is not possible. To function efficiently credit grantors must classify consumers into a number of risk groupings, each of which reflects the practical similarities of the members of the group.1 The sophistication which is applied to classifying consumers into a relatively small number of risk groupings is, of course, a function of the savings which are derived versus the costs which are incurred in the process of abstrac- tion. Thus, with respect to the risk-bearing function of institutional credit grantors, differentiation of borrowers will occur to the degree which each credit grantor considers consistent with profit- or wealth- maximizing behavior. Another form of differentiation of financial services is concerned with the various aspects of the loan itself. The many elements of a loan transaction serve as a ready means whereby institutional lenders can differentiate the basic product, "money." Omitting any legal con- siderations, the primary elements of an instalment credit transaction are as follows: 1) the amount of the loan, . 2) the finance charge, 3) the length of the contract, h) the collateral, 5) delinquency, default, and prepayment provisions, 6) ancillary financial services including collection policy. 1"Is every financial transaction unique because risk evaluation, an essential point, is bound to be subjective? The contention that financial transactions cannot be grouped into common categories must be rejected be- causz it is belied by everyday practice." werboff and Rozen, op.cit., p. 2 7. 66 Within each element there are a number of alternatives from which the credit grantor and/or the borrower may choose. Consequently, there are a rather large number of combinations of loan terms from which the actual financial product may be chosen. In the absence of unequal bargaining power, the loan negotiation is basically a process of trading-off one feature for another by both parties to the contract in order to arrive at a mutually satisfactory loan agreement.1 Lastly, institutional credit grantors attempt to differentiate their product by offering facilities and other nonmonetary factors which augment the benefits the consumer derives from the loan agreement itself. Thus, convenient location, telephone interviews, and payroll deductions are forms of nonmonetary services by which institutional lenders attempt to differentiate their services from those offered by other credit grantors. The existence of these basic forms of financial differentiation led two prominent consumer credit economists to conclude that the con- sumer instalment credit market is an imperfect market; imperfection, of course, denoting the presence of obstacles to the mobility of con- sumers within the market.2 1Of course, in practice, loan terms tend to be standardized or, at least, the variations in loan terms tend to be reduced. Legal restric- tions as well as operating policy contribute to this standardization. But it should be pointed out also that competition has much to do with the bargaining which takes place between applicant and credit grantor. Institutional practices have been known to change to meet the competition 0f other institutional lenders. 2Theodore O. Yntema, "The Market for Consumer Credit: A Case in Imperfect Competition," Annals of the American Academ of Political and SOcial Science, volume l§g ZMarch, 19385, pp. 79-55. Clyde w. Phelps, "Monopolistic and Imperfect Competition in Consumer loans," Journal of Marketi , Volume VIII (April, 1944), pp. 382-393. a- 67 The theory of the structure of a cash instalment credit market to be presented here does not imply that the word "imperfection" should be associated with the connotations which often accompany the word in the economics literature. Instead, the theory establishes that the struc- ture of the market is the result of historical development founded on a sound economic foundation. Given the forms in which differentiation may be manifested, this theory of the market structure permits con- sumers to be highly mobile within the structure, resulting in competi- tion which is intense and innovative and which leads to a smoothly l functioning market. Fbundations of the Imperfect Market Under imperfect capital market conditions, the income constraint present in the perfect capital market is simply not applied uniformly by all types of institutional lenders. Fer reasons to be discussed shortly, the nature of the income constraint imposed by a particular type of consumer financing institution is unique; it is unique with resPect to the determination of the borrower's expected future income available for debt repayment, and it is unique with respect to the risk category in which the consumer is placed. As a result, consumers face a discontinuous supply curve with respect to the institutional Sources of credit. To put it curtly, given the same rate of finance charge, the maximum amount of debt permitted the consumer by any one Particular financial institution will not be the same as the maximum permitted by other financial institutions. I 4- But variations in the application of the income constraint is “Or the only characteriStic of the market structure we are proposing. Some institutional credit grantors impose a constraint which relates the amount of debt to the consumer's wealth position. A consumer's wealth from the point of View of the credit grantor consists of assets which are acceptable to the credit grantor as collateral for a loan. Similar to the income constraint, credit grantors do not apply the same standards to the wealth constraint. The wealth constraint and the income constraint are related. The wealth position of the consumer affects the rate at which the expected value of the consumer's future income available for debt repayment is capitalized. Hence, the lower the wealth position of the consumer, the smaller will be the maximum amount of debt the consumer can purchase, all other things equal. It fbllows that the consumer will be faced with the wealth constraint before he will be faced with the income constraint. There is a third form of constraint that is imposed by all insti- tutional lenders: the moral character of the consumer. Credit grantors consider the consumer's willingness to repay the loan a very important Part of the credit analysis. But the degree to which an evaluation 01‘ the consumer's moral character is relied upon by credit grantors is related to the nature of the institutional lender. A financial insti- tution which imposes a wealth constraint upon its borrowers will tend t° rely less upon an evaluation of moral character than an institutional lender which relies upon the wealth constraint. The basis for the structure of the consumer credit now takes shape. An imperfect capital market is a market in which particular credit grantors ,-—— v 69 impose norms of behavior (constraints) upon consumers which vary from institution to institution. These institutional norms can be cate- gorized as income constraints and wealth constraints. Imperfect capital market conditions arise because the wealth and income constraints are not applied consistently and because they are not internally consistent. The consumer who has acquired the maximum debt permitted by a credit grantor's wealth constraint must seek out lenders who impose only an income constraint in order to increase their debt outstanding. The capitalization rate will not be any lower than that which is indicated by consideration of income and moral character. For the income con— straint and the wealth constraint to yield the same result, the insti- tutional lender expects the consumer to possess a certain level of wealth. The greater is the difference between the actual and the minimum wealth required, the higher will be the capitalization rate. Reasons for the Imperfection of the Market Differences in institutional nonns of behavior arise from two Sources which may not be very unrelated as the reader will readily see. The unrelatedness of the two sources will be assumed, however, in order to introduce a number of factors which bear heavily upon the differences in institutional constraints. The behavior of institutional lenders in the cash instalment loan market has evolved from their respective beginnings as specialized financial institutions. Contrasted with other ferms of econOmic activity, financial institutions have long maintained a higher degree of specialization. When the concept of a multi-service financial (—— v 70 institution was introduced, financial institutions, as to be expected, tended to rely upon its experience and operating policies which had developed over the years of intensive specialization. The evolution of multiple financial services offered by a particular type of insti- tution did not proceed at the same rate and did not originate from the same base of intensive specialization as that of other types of financial institutions. The result: institutional norms that are not identical. we can perceive of two basic steps in the evolution of the multi- service financial institutions. The first step for some types of insti- tutions was the dramatic introduction of an unfamiliar financial service. Although the profitability of such financing was attested in the records of consumer credit companies, which had long been accessible to banks, the latter were for years content to stand aside, allowing the business to be conducted almost entirely by special- ized credit agencies whom they in turn partly or largely financed. One reason for their lack of in- terest in direct lending to consumers was that bankers were uncertain as to the amount of risk entailed in this sort of financing; another was the social stigma attached to it, which led banks to consider questions of community standing and public relations. More fundamental, perhaps, were other factors. The busi- ness of consumer instalment lending differs signifi- cantly from that traditionally engaged in by commercial banks: unit transactions are small, unit loan costs high, and the specialized lending and collection techniques required have been the subject of criticism when employed by other agencies. Finally, the state banking laws did not, in most states, specifically give banks the right to finance consumers on an in- stalment basis at charges in excess of statutory interest rates, so that doubt as to the legal status of bank activities in the field served as an addi- tional restraining influence. It would have been certainly unusual were the commercial banks not to have applied the principles gained from long years of experience in the l 1* John Chapman, op.cit., pp. 25-23. 71 short- and intermediate-term market for business loans to their opera- tions in the consumer instalment credit field. The second step was less dramatic. It involved the almost natural expansion of services to related products. Thus, commercial banks intro- duced indirect consumer financing into their inventory of financial ser- vices following their entry into the market for direct loans to consumers. With respect to finance companies, some companies are adding direct loan services to their already extensive participation in the direct consumer loan market while others are doing just the reverse. Credit unions, too, have begun offering more varied loan services than previously. Inasmuch as the introduction of additional services of a related nature are not independent of the institution's existing services, operating principles tend to be transferred from one service to another until such time as the dynamics of the situation require the introduction of innovations which are radical departures frOm the operating principles which are a carryover from the concept of the financial institution as an intensive specialist in only one type of financial service. Influence of Regulatory Policy For a number of institutions, consumer finance companies and credit unions in particular, regulation in the consumer credit field was the creator of the institution. For other types, such as sales finance com- Panies, regulation occurred after the institution had already entered the market. As a consequence, regulation was likely to resemble the socially acceptable modes of behavior already exhibited by the institu- tion. Rate, loan size, term, and collateral considerations tended to -- . -1 till; .1 {lilulj ._—-—v 72 be formalized by the legislative process. But in either case, financial institutions now take as given the regulatory limits to their behavior. Their policies are formulated in accordance with these limitations. The existence of a regulatory structure which varies from institu- tion to institution is another reason for the existence of the market imperfections to which we have referred. The implications of the regu- latory structure on market imperfections are manifested in two ways, particularly as the result of the regulation of the finance charge. A rational credit grantor explicitly relates risk to the finance charge; for profit or wealth maximization is not independent of the degree of risk which is assumed. Consequently, a given rate of finance charge implies the credit grantor has assumed a conceptually precise degree of risk. But for the loan officer, concepts of risk must be given a more practical meaning. This is especially so for the insti- tution which is faced with a rather low ceiling on the finance charge it is permitted. Consequently, the lower the ceiling on the finance charge, the more accurately must the credit grantor be able to deter» mine the degree of risk which he is accepting. Subjective risk deter- mination is not compatible with a rate structure which allows little room for error, even on a random basis. Conversely, the higher the ceiling, the less is the urgency of the credit grantor to determine risk precisaly. A very high ceiling on finance rates encompasses a large nmnber of risk classes. A low rate ceiling provides for only a few risk classes. The credit grantor is then required to carefully deter- mine risk for a larger proportion of his borrowers than that which is necessary for the credit grantor operating under a higher ceiling. . —_————' ———..‘a 73 Greater precision in determining risk is acquired through the use of a monetary concept of risk. That is, the amount of the potential loss must be estimated and controlled. For a given size of loan, an analysis of the borrower's credit-worthiness on the basis of his moral character is not sufficient. The potential loss of principal must be reduced to the point where the potential loss is consistent with the rate structure. The employment of the wealth constraint is a useful method of reducing risk to manageable proportions; not only in terms of the psychological effect upon the borrower, but primarily because the exercise of a claim against wealth wdll reduce the absolute amount of loss the credit grantor can experience. The wealth constraint thus provides the credit grantor with the means to more accurately measure the risk he is contemplating accepting. Its use overcomes the inexactness of determining risk on the basis of the evaluation of the borrower's credit-worthiness. The wealth constraint provides another benefit to the credit grantor who must operate with a low ceiling on the finance charge. The problem of uncertainty enters every credit decision. There is the uncertainty of making an error of judgement; the need to categorize borrowers into a relatively small number of risk classes is a source of a great deal Of uncertainty. Time provides another source of uncertainty. The less "control" over the borrower the more uncertain the credit grantor is likely to be with respect to the borrower's willingness to repay the loan, given the risk class in which the borrower has been placed. The existence of uncertainty leads to the introduction of a subjective Ill Ill-I‘ll! yl'lllnl 1 i.I.|]-lll.l ‘5‘!— 74 probability system that tends to overstate the degree of risk that is accepted. Such behavior justifies a higher rate of charge by the credit grantor. By providing the credit grantor with more tangible control of the borrower, the accompanying degree of uncertainty will tend to be reduced sufficiently to permit the credit grantor to operate within the ceiling imposed by the public authorities. The lower risk which accompanies a lower rate ceiling is manifested in another fashion: the level of costs of the credit grantor. The wealth constraint is used to limit the potential dollar loss from lend- ing. That the use of this constraint results in the acceptance of better-risk consumers is reflected in the costs of lending; for collec- tion costs and investigation costs are very likely to be lower the better the class of risk which the credit grantor accepts. The evalua- tion of risk solely on the basis of moral character is a costly procedure. The wealth constraint clearly limits the investment necessary to reach more accurate evaluations of risk. One would expect, therefore, that credit grantors who use the wealth constraint would display a cost structure which is below that of credit grantors relying mainly on , l borrower evaluation. Specification of the Market Structure The preceding pages have outlined the foundation for the imper- fections which obtain in the consumer credit market. It is to be lPaul Smith's study for the National Bureau indicates that credit costs are not identical among the various institutional lenders in the market for consumer instalment credit. For credit grantors using a wealth constraint, the level of costs appear to be significantly lower than that of other types of credit grantors. Paul Smith, op.cit. .W—_ A 75 recalled that these imperfections are not to be considered as obstacles to the efficient functioning of the market. On the contrary, these imperfections arise from sound economic bases and they do not prevent the market from functioning efficiently. The remainder of this chapter is devoted to specifying the insti- tutions in the market for consumer instalment credit and describing the manner in which this market functions. The emphasis, however, will be directed toward the consumer cash instalment credit market, for in this way, the functioning of the market can be clearly perceived. The Structure of Supply The supply of consumer credit consists of two conceptually distinct groups of lenders: the primary lenders and the secondary lenders. The basis for the distinction arises from the differential behavior of credit grantors with respect to the use of the wealth constraint. The Primary Lender The primary lender is faced with a legal maximum rate of charge Which requires the more precise measurement of risk associated with the monetary concept of risk. The wealth constraint is employed by the Primary lender to meet this requirement. The fact that most consumer instalment credit is used to purchase durable goods provides the lender with an additional means of reducing the risk of loss by default, a lien on the goods purchased.1 In addition, consumers with a store of liquid or marketable assets can obtain credit from a primary lender by pledging those assets as collateral. l Juster and Shay, op.cit., p. 11. 76 The fact that the primary lender requires access to the consumer's wealth in addition to being satisfied as to the consumer's willingness and ability to repay the loan distinguishes this type of lender from the other type of lender of which we shall speak shortly. And because primary lenders rely on being accessible to the consumer's wealth, their rates of charge will be lower than thOSe imposed by the secondary lenders. Juster and Shay seem to argue that the concept of a primary lender‘ is limited to the single-payment consumer loan market.1 Apparently, Juster and Shay felt that this narrow definition of a primary lender was necessary in order to fit the behavior of credit grantors to the behavior of consumers toward the finance charge, the nature of which they were studying. One source of difficulty is that the selleiquidating nature of instalment loans is itself a control of risk. But it does not go far enough in providing the credit grantor with a monetary concept of risk. The use of a wealth constraint in instalment loan transactions is equally necessary. The wealth constraint must affect all the terms .of the loan arrangement. The length of the contract is affected by the expected disposal value of the collateral. The finance rate and loan size are also affected by the nature of the collateral. In short, all the terms of the loan agreement are not absolutely standardized by the credit grantor unless he expects the nature of the collateral he is accepting to be practically identical. 1Ibid., p. 10. I use the phrase "Seem to argue" because the authors, on page 1 of their monograph, refer to banks and sales finance companies as Primary lenders. But their discussion of the wealth constraint on {ages 10 and 11 differentiate between Single-payment loans and instalment cans. 7? Commercial banks and credit unions are primary cash instalment lending institutions. Commercial banks and sales finance companies are primary indirect instalment lending agencies. This is the result of the fact that all three of these institutions depend upon collateral for the majority of their consumer lending business. Math some variation, these institutions are faced with the lowest ceiling on rates of charge in the market.1 To successfully operate within the legal ceiling on rates, these financial institutions must accurately define the risk they are accepting. As a result, they must be in a position to adjust the terms of the loan agreement such that risk remains consistent with the finance charge. There are two important implications of the economic foundation from which these primary lenders operate. In the first place, cyclical changes in money costs are likely to have a strong influence on total costs of lending. The primary lender must be in a position to transmit these changes, especially upward changes, to his customers. The sensi- tivity of primary lenders to changes in money costs cannot be implemented unless the lenders can accurately correlate rate and money costs. The use of the wealth constraint is the foundation which permits the primary lender to effectively transmit changes in money costs to the demand-side of the market. The ability to determine risk accurately is the basis for sound Price discrimination in the market. That the confidence of the primary 1 This is exclusive of single-payment loans made by other financial institutions such as mutual savings banks and savings and loan associa- tions. 78 lenders to determine risk will vary from credit grantor to credit grantor is hardly a debatable point. If one lender in the market can charge a lower finance rate or offer more attractive terms to a borrower with a given conceptual risk, other primary lenders have a strong im- petus to improve the manner in which they determine risk in order to maintain their share of the market of that given class of risk. In other words, the ability to discriminate is the foundation for compe- tition among primary lenders. Given any degree of consumer sensitivity to the terms of the loan agreement including the finance charge, the primary lending element of the market structure of the consumer cash instalment credit market will be a highly competitive market. The legal ceilings which exist provide the impetus for such competition as long as market rates need not exceed the legal ceiling in order to ensure participation in the market by the lending institution. The Secondary Lender The secondary lender does not rely upon being accessible to the wealth of the consumer in making most of his credit decisions. Risk is measured by the pattern of the borrower's characteristics. For example, three credit—scoring systems in use by national consumer finance companies give no weight to the elements of the loan agreement: amount, maturity, and collateral. The much higher ceiling on the finance charge is the reason secondary lenders have no urgency to determine risk with the accuracy present in the case of the primary lender. Relying almost completely on the income constraint and the evaluation of the moral character of the applicant, secondary lenders 79 view collateral simply as a psychological weapon; there is little or no expectation that exercising claims against wealth will produce significant reductions of potential loss. Because the income constraint is the only constraint employed by the secondary lender, the terms of the loan agreement are frequently more standardized than that which might be expected of primary lenders. The objective of the secondary lender is to arrange the terms of the loan such that the consumer's needs are met and the loan terms place no undue strain upon the consumer. The higher ceiling on finance charge and the less precise means of determining risk provide the secondary lender with the ability to make the loan arrangement as liberal as the borrower may require, the influence of the income constraint notwithstanding. Consequently, contract length and loan size will tend to approach the maximum permitted by the law. The nature of consumer evaluation employed by the secondary lender does not provide a practical basis for rate discrimination. As a result, the finance charge of secondary lenders also will tend to approach the maximum permitted by the law. The tendency for the other elements of the loan agreement to approach their legal maximums also leads to the tendency of the finance charge to approach its maximum. The nature of competition among credit grantors in the secondary Segment of the market structure is unlike the competition which was described for the primary segment of the market. we have noted that rate competition is not very likely among secondary lenders. we have also noted that contract length tends to approach the maximum permitted. Thus, competition among secondary lenders, if it does exist, must take 80 a more subtle form. Geographical obstacles to competition notwithstanding, competition among secondary lenders will revolve partly around the in- come constraint employed by the secondary lenders. Similar to primary lenders, all secondary lenders will not determine the income constraint uniformly. Consumers concerned with their capacity to borrow can shop among the secondary lenders for the one who will offer the most satis- factory terms and/or the largest size of loan. Competition can occur in another subtle sense. Difference in evaluation may lead to adjust- ments in the loan terms. Consumers in relatively high risk classes may be able to find loan terms less restrictive with one secondary lender if they seek such a situation. Belief systems are bound to vary among Secondary lenders. Thus, risky consumensnay be able to stretch out the loan maturity with some secondary lenders. Or, when loan size is somewhat restricted because of high risk, the consumer may be able to find differences in the behavior of secondary lenders toward the maxi- mum loan they are willing to grant him. The nature of the borrower and the nature of the secondary lenders leads to a more subtle form of competition than that which would tend to occur within the primary s°gment of the market structure. The Structure of Demand we noted in Chapter II that consumers may be categorized into two classes: rationed and unrationed. We noted further that the unrationed consumer, in effect, can acquire all of his debt capital from primary lenders because he has not exceeded the wealth constraint imposed by Primary lenders. A number of reasons were cited for the situation of the unrationed consumer. 81 The rationed consumer, on the other hand, has been rationed by the primary lenders through the employment of the wealth constraint. To acquire further debt capital, these consumers must Seek out secondary lenders. As Juster and Shay explained, these consumers tend to be insensitive to the finance charge since they recognize they must pay a higher price. This chapter has provided a rationalization for the higher finance charges in effect at secondary lenders from the supply side. In order to understand the nature of this market structure fully the behavior of rationed consumers will be analyzed. There are two basic reasons for following this course. Firstly, rationed consumers must operate in both segments of the structure. Consequently, the study of their behavior will provide a more complete picture of the mechanism of the market. Secondly, perhaps most importantly, viewing the be- havior of the rationed consumer will allow us to examine the structure of what we have called an imperfect market; for it is not the purpose of this theory of market structure to suggest that such a market struc- ture produces obstacles to acquiring consumer debt capital which lead to exploitation of the consumer or an underallocation of resources to consumers. On the contrary, the market structure hypothesized here can be very fluid; consumers can be very mobile within the geographical limitations of the market. The structure that is hypothesized is based on the historical development of the participation of financial insti- tutions in the consumer credit market and their concomitant regulation by government. It is a market structure based on sound economic prin- ciples exemplified by the income and wealth constraints. The Mechanism of the Market A consumer is never permanently rationed, although many consumers, no doubt, can be considered permanently unrationed. If the reason for borrowing is to purchase a specific durable good, the object of purchaSe 1 may have collateral value acceptable to a primary lender. As long as the consumer has not exceeded the income constraint, a primary lender decides on the basis of the present situation. If the loan is for the purpose of purchasing a durable good which possesses collateral value, the consumer, though previously rationed, may acquire the debt from a primary lender by permitting a claim against the durable good. In other words, any consumer can move between the two elements of the market structure, depending on his situation with respect to wealth at the time of borrowing. Fbr the consumer with little accumulated wealth, mobility between ‘ the elements of the market structure is quite important. Fbr the most \ l \ part, his ability to borrow from a primary lender depends almost ex- , clusively on the object of purchase; that is, whether the object of l ‘ purchase has collateral value or not. In addition, the primary lender 1 will insist, in most cases, that the length of the contract be tied to the nature of the collateral in order to partially ensure that the 1 amortization of the loan proceeds at a rate faster than the rate of w } d°Preciation of the durable good.2 As a consequence, the consumer with 1The nature of the secondary market for the durable good is the key to its acceptability by the primary lender. The degree of accept- \ ability can vary from time to time for a particular durable good and it can Vary from durable good to durable good. Deviations from the relationship between loan amortization and aSSet depreciation imply more risk. The primary lender will adjust thefinance rate to account for such deviations. little accumulated wealth will rapidly approach the maximum debt which would be permitted by the wealth constraint. Credit needs for non- durable purchases must be financed with the secondary lenders segment of the market structure. In order to avoid the undue strain of a very high monthly payment to monthly income ratio, the consumer will seek loan terms which tend to stretch out to the maximum permitted the secondary lender by the law. InaSmuch as the finance charge of second- ary lenders tend toward the maximum permitted by the law, any increase in risk which accompanies the extension of contract maturity is compen- sated by the high rate ceiling for most cases. Consumers with existing wealth can be provided with their credit needs almost eXclusively by primary lenders. When borrowing is for the purpose of purchasing non-durable goods and services, permitting the primary lender a claim against existing wealth will result in accommodation by the primary lender. Of course, the nature of the existing wealth will determine the degree to which the primary lenders will extend credit to this type of consumer. Although existing wealth may permit the consumer to acquire all of his needed debt capital from a primary lender, there is some limitations imposed on his freedom because the terms of the loan are tied to the nature of the collateral. As a result, a consumer with existing wealth may need to seek a longer contract or a higher loan to collateral value ratio than the primary lender would ordinarily be willing to grant. Offering to pay a higher rate will usually permit the consumer to attain his objectives. Thus, for some proportion of the consumer population, the primary lender will need to behave as a quasi-secondary lender if he wishes to acquire a ll'l'l‘u. 1111i 1 share of this market. And in this case, the existence of secondary lenders serves as an upper limit to the conditions a primary lender can impose upon a consumer of this type. Thus, mobility within the structure of the market is evident although it is not employed by the consumer. Finally, there is another group of consumers whose store of existing wealth is large and highly liquid or marketable. These consumers can acquire debt from primary lenders at the lowest rates in the market and on a single-payment basis. These consumers are truly unrationed. The combination of a limited need for debt capital and a large store of liquid or marketable assets marks these consumers as the lowest risk group of the consumer population. Most consumers have access to primary lenders at one time or another with few exceptions; for the need for a secondary lender does not arise until the existing wealth of the consumer is not sufficient to be accept- able to the primary lender. In addition, access to a primary lender will diminish as the needs of credit are directed toward the purchase of non-durable consumer goods. The secondary lender's share of the market rests upon the nature of the accumulated wealth of the consumer population and the relationship between demand for consumer credit and the demand for consumer durable goods. Summary This chapter has estabflished a basis for distinguishing between two types of lenders. The basis for the distinction is the preference of the primary lender to be accessible to the wealth of the borrower ~F—f— 85 in order to accurately relate risk to yield. In short, the nature of the collateral is an integral part of the credit decision of the primary lender. The secondary lender, on the other hand, has no such preference for accessibility to the consumer's wealth. He almost completely relies on the characteristics of the borrower in making credit decisions. As a result of this distinction, the supply of consumer credit may be depicted as in Chart IV>l. Chart IVLl THE SUPPLY OF CONSUMER CREDIT Rate / l Primary l Secondary Lending Lending Rates Rates Dollars Conceptually, there is a significant difference between the highest rate charged by the primary lender and the lowest rate charged by the secondary lender. This is the result of distinctly different bases for determining risk by each of the two types of lenders. The source of the difference in the respective levels of the finance rate is the different methods of risk determination and the differing levels of uncertainty which accompany them. Ca5h Credit vs. Instalment Sales Credit In Chapter I we established a basis for distinguishing between the cash instalment loan segment and the instalment sales credit segment of the consumer credit market. The basis for the distinction was twofold: 86 the differences in the fbrm of the contract, and the differences arising from the participants to the contract. we can now establish that these differences are, for the most part, superficial. Instalment sales contracts generally take two forms: the chattel mortgage and the conditional sales contract. In either case, the bor- rower is not free to dispose of the durable good as he chooses until the loan balance has been paid off. The primary lender, whether he participates in the indirect or direct segment of the consumer credit market operates on the same principles. Legal differences in form are . superficial. Many primary lenders participate in both the direct and indirect segments of the market. As we have previously discussed, operating to another. -\_,——.'—_ _ principles tend to be transferred from one related function The use of the wealth constraint need not be altered to be suitable for application to the indirect segment of the market. The role of the commercial bank in both the direct and indirect segments of the market best illustrates the interrelatedness of these two segments with respect to the use of the wealth constraint. The existence of these two methods of consumer financing are the result of historical relationships which .are an integral part of the evolution of financial institutions in the consumer credit market. I'll": . IIII'uII‘lIII I ' 'fi.‘ ll l||| . [45‘ III I I'll IIIII Ill - III I .ll' 1|.1llllllllu ‘\.ll I‘ll _‘F—-.’— —— CHAPTER IV THE MARKET THEORY AND INSTITUTIONAL FUNCTIONS This is a transitional chapter whose purpose is to lay the founda- tion for the analysis of the approved loan applications at three con- sumer cash instalment credit grantors: the credit union, the commercial bank, and the consumer finance company. To do this, the chapter will be divided into three sections. The first section discusses the relation- ship between risk-bearing and market functions, for the test of the theory involves the analysis of loan and borrower characteristics as the means of describing the behavior of institutional credit grantors. The second Section diScusses the behavior of indirect credit grantors in order to establish a basis for focusing upon the activities of cash instalment credit grantors as a means for examining the validity of the market theory. The last section of the chapter is devoted to developing the hypotheses that will be tested in Chapters V and VI. Risk-Bearing vs. Market Functions The nature of the market structure developed in Chapter III was based on the differential behavior of institutional lenders with respect to the concept of risk determination. But the segmentation of the market for consumer credit is not manifested, in the real world, in terms of risk considerations. The concept of risk is too indefinite for successful Operating behavior in the market. The institutional credit grantor seeks some other basis with which to attract desirable applicants. The need to seek some other basis to attract customers is largely due to the fact 8? II. I‘I‘lln I [gills-lull I} ._‘_—- F— a 88 that consumers are sufficiently unaware of risk concepts to shop intelli- gently for credit on the basis of the risk-bearing function of the insti- tutional lenders. In addition, the uniqueness of each consumer is such that credit grantors would find it very costly to pattern market behavior directly on the basis of risk considerations. In general, the consumer does not conceive of himself as being associated with a given degree of risk. The search for a credit grantor is related to the financing functions which the consumer believes the various types of credit grantors perform. Juster and Shay detected the existence of institutional knowledge on the part of the consumer popu- lation in general: Despite the lack of rate knowledge, consumers seemed to know that certain types of credit are more costly than others. Fbr example, consumers' estimates of the rates, as well as actual rates, tended to be higher than average for credit transactions for purchasing furniture, lower than average fbr transactions in- volving automobiles, and higher than average for small amounts of credit. This degree of knowledge is termed "institutional."l It appears reasonable to suppose also that consumers are aware of the types of institutions to which they may apply fbr credit for specific purposes and the circumstances under which they may receive favorable treatment. The consumer, to reiterate, conceives of a financial institution, not as selective with reSpect to risk, but selective with respect to the goods it will finance or the other circumstances which surround the application such as the characteristics of the borrower and the attitude of the credit grantor toward the various aspects of the loan terms. The View of the consumer toward the institutional __ lJuster and Shay, oo.cit., p. 3. 89 supply of credit is functional in nature rather than abstract. The functional point of view also prevails on the supply side of the market. Although fundamental segmentation of the market may be based upon differing concepts of risk, operating behavior translates risk considerations into more functional lines. The various lending activities which a credit grantor may pursue are made known to the public by means of identification with the goods and services the credit grantor is willing to finance or the circumstances under which he is willing to accommodate a consumer. Regardless of the manner in which the particular credit grantor may conceive of risk, his operating be- havior will be divulged in terms of the lending functions he is willing to perform. A consumer will not be rejected because he is an unaccept- able risk, but because the uSe to which the funds will be put or the circumstances surrounding his application do not coincide with the lending functions of the institutional credit grantor. In fact, the credit grantor often will offer a loan arrangement to the consumer that would be consistent with the credit grantor's lending functions but unacceptable to the consumer. Thus, the consumer often will turn down the arrangement offered by the credit grantor. Because market behavior is manifested along functional lines rather than risk concepts, the observation of the loan borrower characteristics at various types of credit grantors should prove to be an accurate means 0f determining credit grantor behavior. Moreover, examining the functiOnal aspects of institutional lender behavior also provides the means whereby the source of credit grantor behavior can be determined. Thus, the credit grantor whose loans are always secured by high-quality collateral 90 does employ the concept of risk consistent with that of a purely pri- mary lender. It is because of the relationship between risk—bearing and market function that this study will analyze the loan and borrower characteristics of approved loans in order to determine the nature of the credit grantor with respect to his role in the consumer instalment credit market structure. Nature of Indirect Lending Activities The nature of the consumer instalment financing performed by sales finance companies and the indirect sales financing performed by com- mercial banks would provide no insight into the functioning of the mar- ket as postulated in this study. Because collateral is involved in every financing transaction, these types of lenders would be identified as primary lenders. Actually, the situation is not that lucid that observation of loan and borrower characteristics would yield no results. On the contrary, these lenders often face the decision that is faced by cash instalment credit grantors with respect to the relationship between borrower characteristics and loan characteristics. Consequently, it will be worthwhile to examine the nature of indirect instalment lending to demonstrate that, although this type of lender often faces decisions analgous to those of direct cash credit grantors, including them in a sample of credit grantors will not produce useful results. Expical Indirect Finance Behavior Because of the nature of the lender-debtor relationship in indirect finance, the sales finance company must function as a primary lender in 91 in the typical transaction:1 In the typical sales finance transaction the com- modity is the collateral or physical security for the loan, and upon default of payment the seller- lender has the right to seize and resell the com- modity.2 The durability and resale value of the commodity itself are unquestionably important factors, since it is an accepted principle of instalment financing that the commodity purchased shall be the security for the loan. The primary lender usually is assumed to consider solely the nature of the collateral and its relationship to the other aspects of the loan: finance rate, down payment, and length of contract. There is little tendency to evaluate the borrower's characteristics. But the durability and resaleability of the commodity to be financed are the keys to the extent to which the indirect credit grantor will rely on the collateral in determining his risk. He will tend to give greater weight to the borrower's characteristics the more unstable the resaleability of the commodity, and also, the less durable is the commodity. Inasmuch as resaleability and durability vary among the commodities credit grantors will finance, the behavior of indirect credit grantors will vary with respect to the weight given the characteristics of the borrower in evaluating the opportunity to lend. 1Actually, the sales finance company and the sales finance opera- tion of commercial banks are indicative of the purely primary lender only when consumer goods are financed in conjunction with a repurchase or recourse agreement with the dealer. Otherwise, another element enters the transaction: the lenderbdealer relationship. 2WilburC. Plummer and Ralph A. Young, Sales Finance Companies and Their Credit Practices (New York: National Bureau of Economic Research, 19565, n HE 3Ibid., n. 133. 92 The underlying consideration is of course the possibility that repossession and resale will become necessary; in that case the avoidance of loss depends largely on the durability of the com- modity. But the importance attached to durability and resale value necessarily varies from one type of commodity to another, roughly in accordance with the original cash selling price. This ex~ plains why factors relating to collateral security are given more weight in automobile than in diversi- fied financing. Credit grantors, particularly indirect credit grantors, are aware of the relationship between the commodity's durability and resaleability and the need to give greater weight to other factors which are a part of the financing arrangement. An official of an automobile sales finance company declared in an interview on this subject of credit standards that his company had formerly relied pri- marily on resaleability, down payment, and length of contract, but the instability of the used-car market in recent years, also the dealers' demand for smaller down payments and longer contracts made it necessary to give increasing consideration to factors concerning the purchaser himselfz-his income, his Occupation, the ratio of monthly payment to monthly income, and the permanence of his employment. 2 To sample the loan applications of indirect credit grantors would not produce measurable results. The variation of specialization in financing durable goods purchases by indirect credit grantors would create a situ- ation that could not be interpreted with any degree of confidence unless the sample was stratified on the basis of the types of durable goods these lenders finance. Consequently, the empirical evidence to be presented as examples of the behavior of credit grantors will be taken from the cash instalment credit segment of the consumer instalment credit segment of the consumer instalment credit market. It is in this market that credit grantors can freely associate themselves with either the risk concept of the primary lender or the risk concept of the sec- ondary lender or a combination of the two concepts that occurs in the case of the truly diversified lender. Personal Loans Because attention will be focused entirely upon the cash instalment credit segment of the market, it will be useful to clarify the concept of a personal loan and the problems it presents for the analysis to be pursued in the following two chapters. The Federal Reserve System, for purposes of statistical analysis, define personal loans as follows: "Personal loans" include all instalment loans not covered in the previous categories made by financial institutions to individuals for consumer purposes. Nest of these loans are fer such purposes as consoli- dation of consumer debts, payment of medical, educa- tional, or travel expenses, and payment of personal taxes or insurance premiums. Some personal loans are used for the purchase of consumer goods but they are not included under "automobile paper" or "other consumer goods paper" unless they are secured by the goods purchased. Part of the data to be presented in this study are, for the most part, derived from a sample of the personal loans granted by credit unions, commercial banks, and consumer finance companies in Lansing, Michigan. Loans for the purchase of consumer durable goods are included in the data of some of the institutions sampled due to the manner in which their credit applications are filed. In addition, consumer finance 1"Revision of Consumer Credit Statistics," Federal Reserve Bulletin (April. 1953). p. 3&1. 94 companies and credit unions cannot participate in the indirect segment of the instalment credit market. Thus, it is an integral part of this analysis to reveal the extent to which these two institutions extend credit for the purchase of consumer durable goods. Finally, in many cases it was not possible to determine whether the loan was used for the purchase of the commodity which does appear as collateral for the loan. Given these shortcomings, however, the analysis of the personal loans made by the aforementioned institutions does provide a foundation for evaluating the nature of the cash instalment credit segment of the market for consumer instalment credit; for it is with respect to this segment of the market that consumer lending institutions are free to formulate their policy with respect to the manner in which they shall determine risk and the lending functions they will perform. The Hypotheses In order to test, by example, the theory of the market structure presented in Chapter III, two hypotheses will be offered. These hypo- theses concern the emphasis lenders place upon the characteristics of the borrowers and the emphasis lenders place upon the characteristics of the loan. It will be shown, however, that the observation of credit grantor behavior cannot be tested with respect to the characteristics of the borrower. And it is to this purpose, in addition to stating the two hypotheses, that this section is devoted. Behavior of the Secondagy Lender The role of the secondary lender, defined in Chapter III, is to 95 ‘provide a source of cash instalment credit to rationed consumers; con- sumers who lack the wealth necessary to acquire credit from primary lenders. Because the secondary lender will not be accessible to a consumer's wealth to the degree necessary to function as a primary lender, the secondary lender must determine the consumer's creditworthi- ness on the basis of his personal characteristics. It is the pattern of these characteristics which determine the consumer's creditworthiness. But is this pattern invariant among consumers such that it can be ob- served? It will be argued here that the answer is negative, and the hypothesis to be tested in Chapter IV is based on that conclusion. unable to focus upon collateral considerations as the basis for risk evaluation, the secondary lender must employ a less precise (and more uncertain) means of risk evaluation. The existence of a rate structure higher than that of the primary lenders permits the secondary lending institutions to engage profitably in this segment of the con- sumer instalment credit market. Specifically, the secondary lender employs an ordinal concept of risk. Consumers are ranked by a scale of risk. The secondary lender need only be watchful of consumers whose index of risk exceeds that which is consistent with the maximum rate of charge which secondary lenders are permitted and which they usually-charge. Not all loan applications received by consumer finance companies are approved. In the industry, the ratio between loans made and applications received tends to vary widely from one loan office to another, and even within the same office it will change from time to time because the composition and quality of applica- tions is far from uniform. Managers state that credit analysis for small loan customers is more art than science; and as a result of the nebulous nature of this analysis, judgement of the borrower's character becomes very important. However, objective financial data are required also to determine capacity or ability to pay. Usually the applicant must list such personal information as salary, name of employer, number of years on the present job and in the city, major assets owned, such as a house or car, and also all present indebtedness. The application generally is accepted if the applicant had previous dealings with the office and has established a good credit rating through prompt repayments. 1f the applicant is new, the loan will usually be made if he passes the "ability" and "willing- ness" tests to the satisfaction of the manager. Although the consumer finance companies are most typical of the secondary lender concept asserted in this study, the commercial banks or the credit unions are by no means excluded. On the contrary, it is one of the objectives of this study to indicate that differentiation by type of institutional organization leads to inflexibility in thinking through some of the problems connected with the consumer instalment credit market . It is not true, on the other hand, that all consumer finance com- panies are necessarily secondary lenders. The reason has to do with the effect of maximum loan ceilings on the behavior of credit grantors. The difference between the purpose served by credit from the consumer finance company and that from other lenders is easily explained. The legal loan ceiling for consumer finance companies {in Hichigan) is too low to provide the amount of funds necessary for purchase of major durable goods such as auto- mobiles. Ifidle multiple loans from separate licensees offer a legal possibility to the borrower, the higher rate on the first $300 of each loan would make the total interest burden excessively heavy compared with alternative sources of credit (parentheses added) 1 . . . a Thomas G. Gles, Cedric V. Fricke, and Fartha aegar, Consumer Finance Companies in kichigan (Ann Arbor, Michigan: Bureau of Business Research; The University of Michigan, 1901), pp. 39-h0. 2raid. , p. a. L 97 If the consumer finance companies cannot extend credit for the purchase of durable goods that are acceptable collateral in the sense that it becomes the focal point for risk determination, then thesa companies have little choice but to function as secondary lenders. Thus, the wealth of the consumer to which a consumer finance company can be accessible can hardly serve as a basis for the type of risk determina- tion which we have associated with the primary lender. While many loans are unsecured signature notes, collateral is sometimes required. Lenders state that collateral requirements are made principally for their psychological effect upon the borrower rather thap for their value as a source of loan repayment. That collateral considerations are not a major part of the secondary lender's evaluation of creditworthiness is evidenced by the recovery rates resulting from the disposal of collateral security by consumer finance companies. The annual reports of two state agencies charged with the regulation of consumer finance or small loan companies furnish appropriate examples. In Illinois, for 1963, household goods sur- rendered voluntarily by borrowers were sold in 395 cases realizing 18.99 percent of the amount due.2 However, 30.40 percent of the amount due was recovered from the sale of automobiles taken as collateral for loans by licensees in Illinois during 1963.3 The maximum loan per- mitted to be granted by consumer finance licensees in Illinois is $800. lIbid., p. 40. 212§§ Analysis of Reports (Springfield: Division of Consumer Finance; Department of Financial Institutions, State of Illinois, 1964), p. 6. 3l‘bid. , p. 7. 98 The report of small loan licensees in the state of Indiana for 1963 states that the sale of chattels produced net proceeds of $l,h69,680 to be applied against a principal due of $5,289,218.1 This is a recovery rate of 27.8 percent on chattels which consist of household goods, motor vehicles, and other chattels. The maximum loan for small loan licensees in Indiana is $2,006. A number of states, however, provide for very high loan ceilings for the consumer finance companies. Missouri, for example, has no provision in its law for a maximum loan ceiling.2 Ealffo;:;a sets the maximum loan at $5,000.3 For these two states, consumer finance com— i panics EEE function in the primary lending segment of the market because they can finance the purchase of durable goods such as new automobiles that are sufficient for the purposes of focusing upon the collateral as the means for risk determination. Borrower Characteristics The fact that a secondary lender must rely upon the income con- straint and the evaluation of the applicant's characteristics in granting credit to consumers does not imply that a specific pattern to the bor- rower's characteristics will manifest itself. There are two reasons why a secondary lender will not exhibit an observable preference for a certain pattern to the borrower's characteristics. Firstly, a profile of a rationed consumer cannot be constructed. Given the borrower's 1Annual Repgrt and Roster of Small Loan LicenseesI December 21, 1963 Columbus: Small Loans Department; Division of Securities; Department of Commerce; State of Ohio, 196#), p. 6. 2Consumer Finance Companies in Michigan, og.cit., p. 66. 3mm. 99 income, the fact that he is a rationed consumer cannot be discerned from an examination of the other of his characteristics such as age, number in family, residential and employment stability, etc. Even with respect to a consumer's liabilities, there are difficulties of classification; for the consumer may gain access to a primary lender at almost any time by purchasing a commodity that will be acceptable to a primary lender as security for the loan. Secondly, the indefinite manner in which the secondary lender determines risk does not result in a preference for a certain pattern to the consumer's characteristics. The willingness to repay a debt is not manifested in a definite pattern to the consumer's characteristics. The credit-rating is the most important indication of the consumer's willingness to repay his debts. Supported by a higher rate structure, the secondary lender need only be watchful of applicants whose pattern of characteristics including his credit-rating does not justify the extension of credit even at the high rate of charge he is permitted. Thus, the lack of residential stability may be offset by a large degree of employment stability, undesirable occupational classification may be offset by older age, etc. since it is an index of risk which the second- ary lender seeks. In short, the secondary lender need not express a preference for a certain pattern to the borrower's characteristics. Rationed consumers do not possess similar patterns of characteristics and the indefiniteness with which risk is determined does not require the expectation of a certain pattern to those characteristics. 100 Factors Distinguishing Lenders' Behavior The discussions of this chapter lead to the following hypothesis: primary and secondary lenders in the market for consumer cash instalment credit cannot be distinguished on the basis of borrower characteristics. Neither function requires the expectation of an observable preference for a certain pattern to the borrowers' characteristics. This hypo— thesis will be tested in the succeeding chapter. If this hypothesis is correct, the basis for distinguishing among credit grantors in the market must lie with the characteristics of loans granted. Loan size, loan purpose, maturity, rate and collateral charac- teristics are the basis for the classification of credit grantors into the primary and secondary lending segments of the market structure sub- mitted in this study. This hypothesis will be examined in Chapter VI. CHAPTER V BORROWER CHARACTERISTICS AND THE THEORY OF THE MARKET STRUCTURE This chapter is devoted to an analysis of borrower characteristics at each of the three major institutional credit grantors in the consumer cash instalment credit market. The objective of the discussion is to determine to what extent an analysis of borrower characteristics reveals the nature and behavior of institutional credit grantors in the market. More specifically, the aim of this chapter is to present some evidence that may be pertinent to the theory of the market structure which has been set forth in earlier chapters. Conclusions of Previous Studies Mbst of the studies of the/consumer instalment credit marketiand the