How to capture the full extent of price stickiness in credit card interest rates?

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1 Universiy of Wollongong Research Online Faculy of Business - Economics Working Papers Faculy of Business 2012 How o capure he full exen of price sickiness in credi card ineres raes? Abbas Valadkhani Universiy of Wollongong, abbas@uow.edu.au Said Anwar Universiy of he Sunshine Coas Amir Aromandi Universiy of Wollongong, amira@uow.edu.au Recommended Ciaion Valadkhani, Abbas; Anwar, Said; and Aromandi, Amir, How o capure he full exen of price sickiness in credi card ineres raes?, Deparmen of Economics, Universiy of Wollongong, Working Paper 02-12, 2012, 33. hp://ro.uow.edu.au/commwkpapers/243 Research Online is he open access insiuional reposiory for he Universiy of Wollongong. For furher informaion conac he UOW Library: research-pubs@uow.edu.au

2 Economics Working Paper Series 2012 hp:// How o capure he full exen of price sickiness in credi card ineres raes? Associae Professor Abbas Valadkhani School of Economics Universiy of Wollongong abbas@uow.edu.au and Professor Said Anwar School of Business The Universiy of he Sunshine Coas sanwar@usc.edu.au and Dr Amir Aromandi School of Economics Universiy of Wollongong amira@uow.edu.au WP January 2012

3 How o capure he full exen of price sickiness in credi card ineres raes? A/Prof Abbas Valadkhani School of Economics Universiy of Wollongong abbas@uow.edu.au Prof Said Anwar School of Business The Universiy of he Sunshine Coas sanwar@usc.edu.au Dr Amir Aromandi School of Economics Universiy of Wollongong amira@uow.edu.au Absrac: We presen a new approach o evaluae he full exen of price sickiness in credi card ineres raes by modifying he exising asymmeric models so ha hey can be adoped for esing boh he amoun and adusmen asymmeries as well as he lagged dynamic ineria. Consisen wih similar sudies, banks behave asymmerically in response o changes in he Reserve Bank of Ausralia s (RBA) arge ineres rae. Rae rises are passed ono he consumer faser han rae cus and he credi card ineres rae showed a very significan degree of downward rigidiy. Based on he magniude of he pass-hrough parameers obained from shor-run dynamic models, rae rises had a full one-o-one and insananeous impac on credi card ineres raes. However, in absolue erms he shor-run effecs of rae cus were no only less han half of he rae rises bu also were delayed on average by hree monhs. JEL classificaion: E43; E58; G21 Keywords: Ineres raes; Asymmeric behaviour; Credi cards; Ausralia 1

4 1. Inroducion Analysing credi card ineres raes has been one of he growing srands of research in he banking and finance lieraure. Credi card suppliers generally operae wihin a compeiive marke wih many financial insiuions offering heir credi cards wih limied barriers o enry. However, in such a marke i is puzzling as o why credi card ineres raes (compared o oher lending raes) are so high and so sicky downwards, while banks enoy high profis a he same ime. There are a large number of recen sudies ha have analysed he ineres rae pass-hrough of he cenral bank s policy rae o various ypes of deposi and lending raes (see iner alia Hofmann and Mizen, 2004; Chong, Liu and Shresha, 2006; Payne, 2006, 2007; De Graeve, De Jonghe and Venne, 2007; Liu, Margariis and Tourani- Rad, 2008; Payne and Waers, 2008; Chong, 2010; De Haan and Serken, 2011). However, banks asymmeric behaviour in seing he credi card ineres rae has received considerably less aenion in he lieraure, especially in he conex of he Ausralian banking indusry. Previous sudies in oher counries have found ha credi card ineres raes are relaively higher han oher lending raes and show a very significan degree of ineria and downward rigidiy. This has resuled in he rising spread beween credi card raes and oher lending raes. All maor explanaions for he asymmeric behaviour of credi card ineres raes in he lieraure can be grouped ino six caegories: (1) search coss, swiching coss, and adverse selecion (Ausubel, 1991; Lowe and Rohling,1992; Lowe, 1995; Calem and Meser, 1995; Sango, 2002; Berlin and Meser, 2004; Calem, Gordy and Meser, 2006; Agarwal, Chomsisengphe and Liu, 2010); (2) raional or irraional borrowers (Brio and Harley, 1995; Della Vigna and Malmendier, 2004); (3) fixed and variable ineres raes (Sango, 2000); (4) aci collusion beween banks (Kniel and Sango, 2003); (5) opion value of credi lines (Park, 2004); (6) credi card penaly fees and risk (Massoud, Saunders and Scholnick, 2007). 2

5 Providing a comprehensive review of he exising lieraure is beyond he scope of his paper. For a concise accoun of hese sudies see Scholnick e al. (2008). Ausubel (1991), Lowe and Rohling (1992), Lowe (1995) and Calem and Meser (1995) can be considered as four pioneering sudies posing a combinaion of hree explanaions for his puzzle, namely: search coss, swiching coss, and adverse selecion. In heir views, o change credi card providers, consumers may incur wo possible ypes of coss: search coss (associaed wih finding he informaion on alernaive providers) and swiching coss, (he expenses incurring in he process of changing from one provider o anoher). High risk borrowers are usually more inclined o search for lower ineres rae cards because hey hink i is more likely ha hey may use ha deb in he fuure (Ausubel, 1991). Due o his likely phenomenon, financial insiuions hesiae o reduce heir credi card ineres raes because his acion may in fac encourage high risk borrowers o apply for heir producs. According o Calem, Gordy and Meser (2005), borrowers who possess higher credi card balances also have higher search coss. Thus, if a bank unilaerally reduces is credi card ineres rae, i will be appealing o mainly less profiable borrowers who have lower balances. Boh Ausubel (1991) and Calem and Meser (1995) herefore conclude ha banks have no incenive o unilaerally lower heir ineres rae. In a compeiive equilibrium and based on compleely raional individuals, Brio and Harley (1995) suggesed an alernaive explanaion o ha of Ausubel (1991), Lowe and Rohling (1992) and Calem and Meser (1995). In heir view, for wo reasons borrowers coninue o use credi card deb even if is ineres rae is subsanially higher han oher alernaive forms of borrowing: (a) ransacions coss associaed wih he use of non-credi card sources for shor periods of ime are usually high; (b) borrowers ry o smooh heir income and consumpion sreams hrough ime. Brio and Harley (1995) also provide an explanaion for he rising spread beween credi card raes and oher lending raes. Unlike 3

6 oher bank loans, credi cards enable he flexibiliy o borrow more even if consumpion exceeds income, especially when oher loans are more expensive o se up or he loan periods are eiher relaively shor or unpredicable. However, if he spread beween credi card and oher forms of finance becomes significanly wider, he credi card benefis will diminish and evenually low-risk borrowers, who have access o oher loans, will sop using credi card deb. Credi card providers usually offer wo ypes of ineres rae: fixed raes which do no change for long periods and variable raes which move concurrenly wih marke ineres raes. Sango (2000) believes ha such a pricing srucure influences he compeiive srucure of he marke. Adoping a game heory approach, Sango (2000) demonsraes ha he size of firms can also exer a srong influence on he pricing srucure chosen (i.e. fixed or variable raes). Kniel and Sango (2003) offer anoher alernaive explanaion for credi card sickiness based on he possibiliy of aci collusion beween banks. Numerous Saes in he US inroduced he Sae level price ceilings based on Usury Laws in he 1980s while in oher Saes here were no binding ceilings. Kniel and Sango (2003, p.1471) argue ha credi card providers resor o aci collusion by using he ineres rae level of he binding ceiling in some saes as he focal poin for ineres raes in hose saes ha did no have binding ceilings. The main conclusion of a comprehensive review of he lieraure by Scholnick e al. (2008, p.1469) is ha while a large amoun of research has already been underaken on credi cards, debi cards and ATMs, we believe ha here are sill a grea many issues and puzzles ha remain o be resolved. In he conemporary lieraure he asymmeric behaviour of credi card ineres raes could also be referred o as rockes-and-feahers hypohesis. In a similar conex, Bacon (1991) argued ha gasoline prices shoo up like rockes in response o a posiive rise in oil prices and floa down like feahers in response o a fall. Hannan and Berger (1991) and 4

7 Neumark and Sharpe (1992) are among earlier sudies ha have esed he rockes and feahers hypohesis in he conex of he banking indusry. Their horough invesigaion suggess ha, as compared o negaive shocks, consumer deposi ineres raes respond much slower o posiive shocks. Moon (2000) examined he pass-hrough parameers in a mulicounry seing (i.e. Belgium, France, Germany, Ialy, Neherlands and Spain) by reporing only shor-run mulipliers for a panel of 25 credi marke raes and 17 deposi raes and for he period He found ha he volailiy of he money marke rae lowers he passhrough parameers for boh credi and deposi raes, whereas increasing banking compeiion can increase i. This paper aims o develop a general modelling framework ha allows one o examine he full asymmeric effecs of changes in he cos of funding on he variable-ineres rae charged by Ausralian banks and non-bank financial insiuions for credi cards. We consider wo specific issues. Firs, in overall erms, does he credi card ineres rae respond asymmerically o changes in he funding cos? If he funding cos changes, will Bacon s (1991) rockes-and-feahers hypohesis be applicable in he conex of Ausralia s reail credi card raes? Second, when he cash rae, which is known as he federal funds rae in he US, increases by one per cen, on average, by how much and how quickly do he sandardvariable rae for credi cards rise? One should noe ha significan asymmeric rae adusmens can also adversely affec he efficacy of he RBA s (Reserve Bank of Ausralia) expansionary moneary policy. 1 The cash rae is no he only facor ha affecs he lenders behaviour. The decision of individual lenders o change heir ineres raes is also influenced o varying degrees by a number of oher facors such as he exen of securiisaion and he individual bank s exposures o differen ypes of exernal and inernal sources of borrowing. However, he cash 1 The RBA is Ausralia s cenral bank. 5

8 rae has become increasingly poliicised and he focus of much aenion by media commenaors and he public alike. This is no hard o undersand as for some families ineres paymens consiue a subsanial par of heir income and ineres rae changes have a direc and appreciable effec on heir consumer decisions. During periods of boh increasing and decreasing raes, he media no only focuses on which lenders are raising or lowering heir raes more quickly in response o he direcion provided by he cash rae, bu also he exen o which he change in he cash rae is passed on o borrowers. In he conex of morgage raes banks have responded in a variey of ways, wih some usifying apparenly excessive rae rises ouside he RBA cycle as being due o he increased cos of funding, while ohers adop a sraegy of rae rise resrain o capure marke share. Paricular groups of lenders (especially, credi unions and building socieies, morgage originaors, and so on) have also used heir varying responses o he cash rae for publiciy purposes aimed a levering heir consumer-friendly credenials, especially agains he maor banks. Mos of he previous sudies have focused on he asymmeric pass-hrough of funding coss ino morgage-ineres raes, an issue which is by no means Ausralia specific. Oher developed counries are also facing he same dilemma. For insance, Corvoisier and Gropp (2002) and Bikker and Haaf (2002) have highlighed subsanial differences across European counries in erms of he pass-hrough of moneary policy ineres rae changes ino money marke raes. Bikker and Haaf (2002) examined he banking secor compeiion in 23 counries and discovered ha compeiion is much weaker in local markes. Payne and Waers (2008) horoughly analysed he long-run ineres rae pass hrough of he federal funds rae o he prime rae over he period February 1987 o Ocober They sae ha he response of he prime rae o changes in he federal funds rae appears asymmeric. Payne (2007, 2006) has also proposed several useful momenum hreshold auoregressive models in he lieraure on ineres rae pass-hrough from he federal funds 6

9 rae o morgage raes. He has found ha he morgage raes are co-inegraed wih he federal funds rae in he long run bu wih incomplee ineres rae pass hrough in he shor run. A recen sudy found ha he pass-hrough of official ineres rae changes ino morgage raes in he Neherlands is only abou half of he Euro-zone average (De Haan and Serken, 2011). Lile empirical work has been conduced regarding he dynamic effecs of posiive and negaive changes in he cenral bank s policy rae on credi card raes. However, here are numerous sudies in he lieraure ha found evidence of asymmeric pricing for oher lending raes (e.g., Haney, 1988; Allen, Ruherford and Wiley, 1999; Hofmann and Mizen, 2004; and De Haan and Serken, 2011). Liu, Margariis and Tourani-Rad (2008) conduced a comprehensive sudy by using New Zealand s monhly daa on various morgage, deposi and lending raes for he period They quanified he exen of pass-hrough and adusmen speed of reail ineres raes in response o changes in benchmark marke raes by using he Phillips and Lorean (1991) mehodology. They found ha no only he long-erm pass-hrough of reail raes do vary significanly across differen raes bu similar o Kim and Nguyen (2008) hey also argue ha changes in he policy rae can exer more influence on shor-erm ineres raes. Wih some evidence of asymmery in he adusmen of reail raes, hey conclude ha since 1999 he Reserve Bank of New Zealand s ransparency in seing is arge policy rae has reduced he insrumen volailiy and enhanced he efficacy of moneary policy. Lowe and Rohling (1992) and Lowe (1995) invesigaed he degree of sickiness in Ausralia s various deposi and lending raes including credi cards by comparing hem in he pre- ( ) and pos- ( ) deregulaion periods. 2 They found ha he credi card ineres rae was he sickies rae and here was no sign of observing less rigidiy in he 2 Prior o 1985 he maximum rae ha could be charged on credi cards had been se a 18 per cen per annum by he Reserve Bank of Ausralia. In April 1985, his rae was deregulaed. 7

10 pos-deregulaion era. Lowe and Rohling (1992) saed ha swiching and search coss can be he mos criical reasons behind he ineres rae sickiness in he Ausralian banking sysem. 3 Lim (2001) examined he asymmeric adusmens beween hree Ausralian bank ineres raes: a bank bill rae, a loan rae and a deposi rae. She uses a mulivariae asymmeric error-correcion model o capure he long- and shor-run relaionships beween he levels of he raes and shor-run relaionships beween he changes in he raes. Her empirical resuls indicae ha banks value heir borrowing cusomers and end o pass on decreases in he loan raes faser han hey pass on increases (Lim, 2001, p.146). 4 Lim s resuls are in sharp conras wih previous Ausralian sudies (Lowe and Rohling, 1992; Lowe, 1995; Kim and Nguyen, 2008) as well as inernaional sudies (Hannan and Berger, 1991; Neumark and Sharpe, 1992; Payne, 2006, 2007; Allen and McVanel, 2009; De Haan and Serken, 2011). Kim and Nguyen (2008) examine he effecs of he RBA and he U.S. Fed s arge ineres rae announcemen news on he Ausralian financial markes over he period , including he 90 day bank bills, 3 year and 10 year bond raes. They found evidence of asymmeric news effecs on ineres raes where hey respond more srongly o unexpeced rae rises han rae falls. However, he news effec is sronger a he shor-erm ends of he ineres raes (Kim and Nguyen, 2008, p.392). In his paper we address an imporan policy issue no recenly ackled in he Ausralian conex. The maoriy of previous sudies have esed for asymmeric effecs of changes in he cenral bank s policy rae by using a Wald es in which wo coefficiens corresponding o posiive and negaive changes in he lagged error correcion erms were assumed o be equal. 3 For a comprehensive and criical review of he RBA s credi card reforms, see Gans and King (2003). 4 Using monhly daa, Lim (2001) has esed only for he firs order auocorrelaion and he firs order ARCH erm (see Table 5, p.145). 8

11 In oher words, as i is demonsraed in he nex secion, hey have esed for he adusmen asymmery (e.g. see Sarno and Thornon, 2003; Chong, Liu and Shresha, 2006; Liu, Margariis and Tourani-Rad, 2008; Chong, 2010). If he policy rae was no co-inegraed wih a paricular lending rae, hen he proposed asymmeric models in such sudies would have become symmeric. However, in his paper we argue ha even if he lending rae is no co-inegraed wih he policy rae, i is quie possible ha shor-run posiive and negaive changes in he cenral bank s policy rae may sill exer differen effecs on he corresponding lending rae. In oher words, he amoun asymmery should also be esed bu wihin a dynamic framework. I should be noed ha Lowe and Rohling (1992) proposed a simple asymmeric model which was used for esing he amoun asymmery. However, in heir model only posiive and negaive changes in he cash rae a ime were allowed o impac on he lending raes (see Table 4 in Lowe and Rohling, 1992, p.25), whereas in our proposed models he amoun asymmery is esed allowing up o 12 monh lag. Our analysis is underaken wihin a sample period during which he RBA has conduced moneary policy by seing he desired ineres rae on overnigh loans in he money marke. This paper offers an analyical modelling framework o quanify he full exen of asymmeric rae changes (if any), resuling in greaer efficiency and ransparency of he lending marke. The resuls and policy implicaions of his paper increases our undersanding of he credi card lending marke in Ausralia and are beneficial o all borrowers and various governmen regulaors, which can play an imporan role in marke efficiency and consumers proecion. The res of his paper is srucured as follows. In Secion 2 various heoreical models are posulaed which capure wo possible forms of asymmeric behaviour (i.e. he amoun and adusmen asymmery) as well as he dynamic asymmeric responses of he lagged dependen variable. Secion 3 discusses he choice of our sample period, he descripive saisics of he 9

12 daa employed followed by he resuls. Secion 4 presens he empirical resuls of he longand shor-run credi card ineres rae models as well as he policy implicaions of he sudy. Secion 5 provides some concluding remarks and he final secion presens he agenda for fuure research. 2. Theoreical framework In order o capure he long-run relaionship beween he cenral bank s policy rae and he credi card cash rae, following Rousseas (1985), we uilise equaion (1) in which financial insiuions se heir sandard variable rae as a mark-up on he cash rae. Tha is: i r (1) 0 1 where: i =he sandard variable ineres rae a period (as a percenage) for credi cards. r =he cash rae (as a percenage) prevailing a ime, 0 and 1 are he average of banks mark-up and pass-hrough parameers, respecively, and =he whie noise error erm. Several oher sudies in he lieraure have also specified similar long-erm relaionships beween he policy rae and various lending and deposi raes (see iner alia Heffernan, 1997; Chong, Liu and Shresha, 2006; Toolsema and Jacobs, 2007; Liu, Margariis and Tourani- Rad, 2008; De Haan and Serken, 2011). Sandard uni roo ess, such as he Augmened Dickey-Fuller (ADF) es, he DF es wih GLS derending (Ellio, Rohenberg, and Sock, 1996) and he Kwiaskowski-Phillips-Schmid-Shin (KPSS, 1992) es as well as he Lee and Srazicich (2003) es, which endogenously incorporae wo srucural breaks in he esing procedure, are used in he nex secion o ensure ha our empirical resuls are no biased owards he erroneous non-reecion of he non-saionariy hypohesis. Since boh variables in equaion (1) are I(1), in he nex sep he aim is o es if he reail credi card rae is co- 10

13 inegraed wih he cash rae. Following he Engle-Granger wo-sep procedure if he wo variables are co-inegraed, hen he saionary residuals resuling from equaion (1) could form an error correcion mechanism (EC), represening he shor-run deviaion from he longrun equilibrium. Sandard co-inegraion ess (Johansen, 1995) implicily assume a symmeric adusmen process bu if he adusmen process is asymmeric or if he loan raes are sicky downwards, hese ess can lead o misleading resuls. In oher words, he Engle-Granger ype ess wih a linear adusmen procedure will be inappropriae when he dynamic adusmen of loan raes in fac exhibis non-linear behaviour. One alernaive is o use he hreshold co-inegraion es proposed by Granger and Lee (1989), Enders and Granger (1998) and Enders and Siklos (2001). Wih some modificaions he maoriy of previous sudies (see iner alia Sarno and Thornon, 2003; Chong, Liu and Shresha, 2006; Liu, Margariis and Tourani-Rad, 2008; Chong, 2010) have used he following shor-run dynamic model based on he assumpion ha he corresponding wo ineres raes are co-inegraed: q q (2) i r i EC EC v EC ˆ is he esimaed residual obained from equaion (1), denoes he symmeric shor-run effecs of changes in r on i a ime -, and is he symmeric effec of changes in he h lagged dependen variable, where =1,2,,12). The superscrips + and denoe he posiive par and negaive par of EC, respecively as defined below:,0 if 0 and 0 if 0 EC max EC EC EC EC EC EC (3),0 if 0 and 0 if 0 EC min EC EC EC EC EC EC (4) 11

14 In equaion (2) and are he error-correcion parameers associaed wih posiive and negaive values of he EC -1 par, which are expeced o be negaive. If he null hypohesis vs. is reeced, one can argue ha he adusmen process owards he longrun equilibrium is asymmeric and hence here is evidence of adusmen asymmery. If, hen a lagged negaive disequilibrium beween he acual ineres rae and is equilibrium pah resuls in a relaively swifer error correcion as compared o he case of a lagged posiive disequilibrium. This can easily be usified as financial insiuions prefer o increase he acual loan rae o is desired pah immediaely when EC 1 0. On he oher hand, when he lagged-acual reail rae is above he equilibrium pah, banks may have less desire o lower heir rae o is equilibrium pah, causing he speed of adusmen o be more sluggish or someimes non-exisen. Thus, in he case of adusmen asymmery. In he absence of he adusmen asymmery (i.e., ), equaion (2) can be rewrien as: q i r i EC + v q (5) If i and r are no co-inegraed, hen in equaion (2) he error correcion erm will disappear and one may use equaion (6) insead: q i r i + v q (6) Therefore, if wo ineres raes are no co-inegraed or if here is no adusmen asymmery, one may end up using a symmeric model such as (6) and (5), respecively. However, i is quie possible ha shor-run posiive and negaive changes in r (wih differen lags) may sill have asymmeric impacs on he dependen variable. Similarly posiive and negaive changes in i can also have differen effecs on i. In his paper we propose equaion (7) as an 12

15 alernaive and flexible framework which can be used no only for esing boh he adusmen ( ) and amoun ( i i ) asymmeries in he shor run bu also for he pahdependence (sickiness) asymmery ( i i ): q q q q (7) i r r i i EC EC v where and are he shor-run effecs of posiive and negaive changes in he cash rae on reail ineres rae series a ime -, respecively, and and are he effecs of posiive and negaive changes of he dependen variable wih - lag, respecively., r and i, i r are also defined similarly o EC and 1 EC. 1 I should be noed ha Allen and McVanel (2009) and De Haan and Serken (2011) have recenly used a model which allows us o es boh he amoun and adusmen asymmeries in a shor-run dynamic model for morgage raes. However, in heir models i is assumed ha. To he bes of our knowledge, none of he previous sudies have uilised a general i i model as flexible as equaion (7). In equaion (7) he exen of he amoun asymmery depends on he difference beween q 0 q and 0. In oher words, he higher he difference, he more he exen of he amoun asymmery. I is also hypohesised ha rae rises have some immediae effecs on he reail raes (say for insance only 0 and 1 wihin he firs monh o be saisically significan), whereas in he case of rae cus he lagged effecs are exhaused wihin a longer period such as he firs 12 monhs (i.e., 0, 1,..., 12). Therefore, in our model he shor-run effecs of changes in he cash rae on he credi card rae are allowed o be differen in magniude as well as hrough ime. 13

16 Using equaion (7), a Wald es can also be employed o es he amoun asymmery. If he null hypohesis vs. (for all values) is reeced, here will be evidence of amoun asymmery. This means ha shor-run changes in he cash rae can exer asymmeric effecs on he credi card rae. Accordingly, if , hen banks pass hrough shorrun ineres rae rises more han rae decreases. For a deailed discussion of he disincion beween amoun and adusmen asymmeries in he lieraure see Chen, Finney and Lai (2005), Bachmeier and Griffin (2003), Beendorf, van der Gees and Kuper (2009), Allen and McVanel (2009) and De Haan and Serken (2011). In a similar way, if he null hypohesis vs. (for all values) is reeced, one may argue ha posiive and negaive lagged values of he dependen variable have differen impacs in equaion (7). For example, if 0 and 0, ceeris paribus one may hen conclude ha he reail ineres raes are sicky downwards. 3. Daa I should be noed ha Ausralia s approach o moneary policy has undergone significan changes over ime. From he mid-1970s unil 1985, based on he assumpion of a srong and persisen relaionship beween inflaion and he supply of money, moneary policy was conduced by argeing he annual growh of M3. However, in 1985 his policy was abandoned because deregulaion of he financial sysem made M3 a misleading guide o he sance of moneary policy (Grenville, 1990). From 1985 o 1988 a checklis approach was adoped, whereby a muliude of indicaors such as, moneary aggregaes, he GDP growh rae, he shape of he yield curve, exchange raes, and he unemploymen rae were considered prior o he implemenaion of moneary policy. The checklis approach was also 14

17 unsuccessful and finally disconinued in 1989 due o he impossibiliy of monioring he above indicaors which could provide conradicory policy signals. Since 1990, he RBA has conduced moneary policy by seing he desired (arge) ineres rae on overnigh loans in he money marke. This year has been considered as he saring poin for our sample period. Through he moneary policy ransmission mechanism, changes in he cash rae are ulimaely refleced in he raes on all lending insrumens in line wih he desired policy inen. The cash rae in Ausralia is now considered he baseline for he various ineres raes paid by borrowers. Fig. 1 suggess ha during our sample period, which consiss of monhly daa from January 1990 o Ocober 2011, here is a very close relaionship beween he cash rae and credi card rae bu a he same ime he spread beween he credi card rae and he cash rae has been gradually widening since All our monhly daa have been obained from he RBA (2011, Saisical Tables F1 and F5). [FIG. 1 ABOUT HERE] Brännäs and Ohlsson (1999) sugges ha he deecion of asymmery depends on he sampling frequency of he series. They argue ha he use of aggregaed frequencies (i.e., annual) may obscure he nonlineariies or asymmeries ha exis in a series. They found ha asymmeric monhly series may become symmeric when aggregaed o quarerly or annual frequencies (Brännäs and Ohlsson, 1999, p.341). Therefore, in his paper, we use monhly daa o deec any discernable asymmeric behaviour no easily observable in he raw and aggregaed daa. As can be seen in our resuls presened in he nex secion, he effecs of posiive and negaive changes in he cash rae on he credi card rae appear o be exhaused wihin he firs hree monhs. Therefore, his confirms Brännäs and Ohlsson s poin ha he 5 The difference beween he credi card rae and he cash rae increased from 4.89 per cen in January 1990 o per cen in Ocober

18 use of annual ime series in lieu of monhly could have masked he exising nonlineariies or asymmeries in he series. Table 1 presens he descripive saisics and he uni roo es resuls for all of he variables employed in his paper. During he sample period he average credi card rae was 17.7 per cen, ranging from a minimum of 14.4 in May 1994 o a maximum of 23.5 in January Wih a sandard deviaion of 2.44 per cen, he credi card rae showed a slighly less variabiliy han he cash rae (3.20 per cen), paricularly afer he adopion of he RBA s inflaion argeing policy in Based on he repored Jarque-Bera saisics, he null hypohesis of normaliy is reeced a any convenional level for all series as heir disribuions are posiively skewed and show a ypical lepokuric paern wih he kurosis saisic well exceeding 3.0. An imporan sep before underaking our empirical invesigaion is o deermine he ime series properies of he daa. This is an imporan issue since he use of non-saionary daa in he absence of co-inegraion can resul in spurious regression resuls. To his end, hree uni roo ess, i.e. he ADF es, he DF es wih GLS Derending (Ellio, Rohenberg, and Sock, 1996) and he Kwiaskowski-Phillips-Schmid-Shin (KPSS) (Kwiakowski e al. 1992) es, have been adoped o examine he saionariy, or oherwise, of he ime series daa. In his paper he lowes value of he Schwarz crierion (SC) has been used as a guide o deermine he opimal lag lengh. Unlike boh he ADF es and he DF es wih GLS, he KPSS es has he null of saionariy, and he alernaive indicaes he exisence of a uni roo. In Table 1 we have also repored he resuls of he Lee and Srazicich (2003) es, which endogenously incorporaes wo srucural breaks in he esing procedure. The resuling wo break daes for individual series are also repored in Table 1. Irrespecive of which es is considered, i appears ha our wo ineres rae series are I(1). [TABLE 1 AND FIG. 2 ABOUT HERE] 16

19 4. Empirical resuls In his secion, we firs use monhly daa for he period January 1990 Ocober 2011 o esimae he long-run relaionship beween he cash rae (r ) and he credi card rae (i ) by he OLS mehod. The esimaion resuls are presened in Table 2. The average mark-up coefficien for i is 13.6 per cen. Since credi cards are usually riskier han oher ypes of personal loans, he esimaed high mark-up is quie usifiable. The long-run pass-hrough parameer is esimaed a 0.67 per cen, which appears o be of consisen sign and order of magniude and highly significan. This means ha on average he long run credi card rae is 7.1 per cen ( ) more han he cash rae. We also esed he null hypohesis ha he long-run pass-hrough parameer is equal o 1, i.e. H : 1 vs H : This hypohesis was reeced a he 1 per cen level of significance (see Table 2) and as a resul he spread beween he credi card rae and he cash rae has been widening (see Fig. 1). We have also provided he recursive esimaes of boh he mark-up and he pass-hrough parameer in Fig. 2. I seems ha boh he mark-up and pass-hrough parameers enoy relaive sabiliy around he esimaed mean value since 1993, when he RBA adoped he inflaion argeing policy. According o he resuls of four uni-roo ess presened in Table 2, i seems ha he resuling residuals obained from he OLS esimaion of equaion (1) are I(1) despie considering wo endogenous breaks in he Lee and Srazicich (2003) es. Therefore, one canno argue ha he credi card rae is co-inegraed wih he cash rae. The widening spread beween he wo series presened in Fig. 1 could also parly explain he absence of coinegraion. Similar resuls were obained by Lowe (1995, Table A1) 17 years ago in his comprehensive sudy of he linkage beween he cash rae and Ausralia s lending raes including credi card rae. 6 6 This could be he reason why boh posiive and negaive changes in he lagged residuals (as he error correcion erms) are no saisically significan in he esimaed Model I (see Table 3 in he nex secion). 17

20 As discussed in he previous secion, we firs esimae equaion (7) and presen he resuls in Table 3. In erms of deermining he opimal lag lengh (q) in equaion (7), given ha we are using monhly daa, an upper band of 12 lags was allowed. Following he generalo-specific mehodology, insignifican variables in equaion (7) were omied on he basis of a baery of maximum likelihood ess. We imposed oin zero resricions on explanaory variables in he unresriced (general) model o obain he mos parsimonious and robus equaion. We found ha he cash rae is weakly exogenous wih respec o he dependen variable. This usifies he use of he OLS mehod o esimae our shor-run dynamics models based on an asymmeric version of he Engle-Granger wo-sep procedure. This is no couner-inuiive as he cash rae is direcly conrolled by he RBA as a policy variable. The weak exogeneiy es resuls are available from he auhors upon reques Shor-run dynamic models for i Le us focus on he shor-run dynamic asymmeric model for i. As menioned earlier he error correcion series is I(1) (see Table 2) and a he same ime i is no saisically significan in Model I (see Table 3). We have hus excluded he EC -1 erm o obain Model II. I should be noed ha he oher esimaed coefficiens in boh Models I and II remain very similar in erms of heir magniudes and saisical significance. Since i and r are no coinegraed, we only focus on he inerpreaion of Model II below. [TABLE 2 AND FIG. 3 ABOUT HERE] According o he resuls of Model II presened in Table 3, all of he esimaed coefficiens are saisically significan a he five per cen level or beer and have he expeced heoreical signs. Model II also performs well in erms of goodness-of-fi saisics. The adused R 2 is 0.42 and he overall F es reecs he null hypohesis a he one per cen level of significance. Furhermore, i passes a baery of diagnosic ess and shows no sign of 18

21 serial correlaion (see he Breusch-Godfrey LM ess), misspecificaion (see he Ramsey RESET es), heeroskedasiciy (see he ARCH, Whie and Breusch-Pagan-Godfrey ess) and insabiliy (see he Chow forecas ess in hree differen forecasing periods). The only diagnosic es ha Model II could no pass was he Jarque-Bera normaliy es of he residuals. This was unavoidable given he use of monhly daa. One problem associaed wih he analysis of he relaionship beween he cash rae and he credi card rae is non-consancy or insabiliy of he esimaed coefficiens which can creae economic and economeric complicaions in deriving any inference from he empirical model. Therefore, parameer consancy is pivoal in modelling changes in he credi card rae. We have evaluaed our preferred esimaed shor-run model (i.e. Model II) by a number of recursive sabiliy ess which are displayed in Fig. 3 in he following order: a b c d e f g h i k l where panel (a) displays he recursive residuals; (b) depics he CUSUM es; (c) shows he one-sep forecas es; (d) is he n-sep forecas es; and panels (e) o (l) presen he recursively esimaed eigh coefficiens in exacly he same order ha hese coefficiens appear in Model II in Table 3 (from op o boom). These evaluaive ess are useful in assessing sabiliy of a model, as recursive algorihms avoid arbirary spliing of he sample. Overall, he graphical ess for sabiliy repored in Fig. 3 suppor he in-sample consancy of all of he esimaed coefficiens, wih he only wo excepions being he coefficiens of and which were subec o minor changes around Sepember r Ceeris paribus, if in he shor run he cash rae had increased, say by one per cen in a paricular monh, his would have immediaely led o a rise of per cen in he credi card rae. On he oher hand, a similar one per cen rae cu would have resuled in only per cen fall a ime and a furher per cen a ime -3. The oal shor-run effec associaed wih he RBA s rae cu would hen be only per cen wihin he firs hree 19 r

22 monhs ( ), whereas he corresponding effec for a rae rise would be an immediae per cen increase. Thus, in absolue erms he sum of shor-run effecs of rae cus were less han half of he rae rises. Wha abou he adusmen asymmery? Since boh and are saisically insignifican (as a resul of he lack of co-inegraion beween i and r ), i is clear ha he adusmen asymmery is no applicable. However, i appears ha he credi card rae is very q q ˆ 1 1 sicky downwards because ˆ. Due o he persisence of ineres raes in he pos era, he esimaed coefficiens of he lagged dependen variable are also saisically significan, especially hose of negaive changes a ime -1, -10 and -12, furher supporing he downward sickiness hypohesis. This proffers suppor for he shor-run applicabiliy of he rockes-and-feahers hypohesis in he conex of he credi card marke in Ausralia. The resuls of Model II in Table 3 show ha he effecs of i on he dependen variable are saisically significan a only one lag -1 ha is ˆ However, he effecs of i on he dependen variable were saisically significan a -1, -10 and -12, yielding o he sum of he lagged dependen variable coefficiens q Therefore, one may conclude ha Ausralian credi card raes face downward rigidiy when he RBA reduces is cash rae. We can use equaions (8) and (9) o approximae he oal effecs of a one per cen rise or fall in he cash rae on he credi card rae, respecively: i r 0 q (8) i q r 1 ( ) 1 1 (9) 20

23 I should be noed ha a one per cen rae cu (compared o a rae rise), no only has a smaller oal effec (0.43 vs. 1.46) bu also i akes longer o evenuae. We have also formally esed he absence of he amoun asymmery by using a Wald es. Using he esimaed Model II presened in Table 3, he null hypohesis vs. is easily reeced a he one per cen level as F=(1,241)=9.87. This is no surprising given he oal long-run effecs of posiive and negaive changes in he cash rae obained in equaions (8) and (9) are so differen. One can hus conclude ha in he conex of credi cards here is srong evidence of he amoun asymmery. As o he sickiness hypohesis, we have esed anoher null hypohesis in which. Given F(1,241)=6.70, he null is once again reeced a he one per cen level of significance. Hence, based on hese resuls, one can argue ha here is convincing evidence for he exisence of boh he amoun asymmery and sickiness hypohesis in he conex of Ausralia s credi card raes Policy implicaions Alhough our resuls are consisen wih previous sudies, our proposed model is capable of capuring all possible ypes of asymmeric movemens in he daa. An overwhelming maoriy of previous sudies sugges ha here is a grea deal of asymmery in he shor-run changes in he credi card loan raes. Researchers from oher counries which could be exposed o banks asymmeric behaviour in seing heir various ineres raes may also find our proposed model and resuls useful. This paper can assis borrowers and relevan governmen regulaors o quanify he exen of he asymmeric behaviour exhibied by he banking indusry as a whole. Borrowers are eniled o know why rae rises have been passed ono hem faser han rae cus and vice versa. This paper benefis all borrowers hrough a beer undersanding of credi card raes, he cenral bank hrough specific knowledge of he effecs of is moneary policy on money marke ineres raes, and he regulaors in enhancing 21

24 ransparency and compeiion in consumer lending. The resuls presened in his paper reveal ha he incomplee credi card rae pass-hrough is relaively large and persisen, requiring in urn a closer governmen monioring and scruiny. 5. Conclusion Banks asymmeric behaviour in seing various loan raes has been a maor cause of concern in he banking and finance lieraure. However, lile empirical work has recenly been conduced regarding he dynamic effecs of changes in he cash rae on Ausralia s credi card ineres rae. This paper is among a few sudies ha have aemped o model hese wo raes and race ou he lenders dynamic asymmeric responses o changes in he funding cos over ime. Specifically, his paper aemps o rigorously es he robusness of he rockes-and-feahers hypohesis in he Ausralian banking conex. This paper uses all available monhly ime series daa (January 1990 o Ocober 2011) o model he inricacies associaed wih he dynamic inerplay beween he cash rae and he reail-variable ineres rae for credi cards. Our aim is o modify he exising asymmeric models in he lieraure o capure wo forms of asymmeries, namely, he amoun and adusmen asymmeries. Since he credi card rae is no co-inegraed wih he cash rae, one canno es for any evidence of he adusmen asymmery. However, i is found ha he credi card ineres rae rises more quickly han i falls in response o changes in he funding cos. In oher words, a an aggregae level, rae rises are passed ono he consumer faser han rae cus. In erms of he magniude of he pass-hrough parameer in our preferred shor-run dynamic model (i.e., Model II), rae rises had a full one-o-one and insananeous impac on he credi card rae. However, he effecs of rae cus were delayed up o hree monhs. Based on our resuls, we found a very significan degree of downward rigidiy and pah-dependency in erms of changes in he credi card rae. Similarly o previous sudies we found ha when 22

25 he RBA reduces he cash rae he Ausralian banks are relucan o lower heir reail credi card raes and do heir bes o delay such an acion for as long as possible. Our proposed models can also be easily adaped o examine he full exen of price sickiness in he conex of oher ypes of reail and wholesale ineres raes, including hose for personal loans, morgages and business loans. 6. Agenda for fuure research In his paper we have esablished ha he rockes-and-feahers hypohesis is applicable a an aggregae level in Ausralia s credi card marke. On our agenda for fuure research, our aim will be o purchase consisenly-defined weekly (credi card) ineres rae daa for over 100 bank and non-bank financial insiuions from CANSTAR ( Such a disaggregaed and weekly sudy can reveal in which bank or non-bank insiuions ineres rae pass-hrough is more incomplee and he exen of he sickiness and asymmeric adusmen is greaer. We can hen describe he main characerisics of such lending insiuions. For example, are he leaders of rae rises mainly big banks, and if so, which one? Have such banks mainained a similar posiion in he marke hrough he sample period? One can idenify he bank-specific opporunisic behaviour in he credi card marke and reveal excessive profieering by he paries involved due o marke inefficiency or aci collusion. The resuls of such a large-scale proec will enable us o idenify he leaders and followers of reail rae changes (if any). This ype of informaion could provide consumers wih more specific forward informaion abou he expeced dynamics, he exen of ineres rae passhrough and he bes bank o choose. 23

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