Research " FACTORING IN BRAZIL - AN INFORMATION ASYMMETRY APPROACH " potx

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FACTORING IN BRAZIL - AN INFORMATION ASYMMETRY APPROACH

BY

CLECIO JOSE BORTONI DIAS

Bach., Universidade de Brasilia, 1993

A.M., University of Illinois at Urbana-Champaign, 1995

THESIS

Submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Economics

in the Graduate College of the

University of Illinois at Urbana-Champaign, 2001

Urbana, Illinois

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UMt Number: 3017068 ® UMI UMI Microform 3017068

Copyright 2001 by Bell & Howell Information and Learning Company All rights reserved This microform edition is protected against

unauthorized copying under Title 17, United States Code

Bell & Howell Information and Learning Company 300 North Zeeb Road

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UNIVERSITY OF ILLINOIS AT URBANA-CHAMPAIGN THE GRADUATE COLLEGE

FEBRUARY 1999 (date)

WE HEREBY RECOMMEND THAT THE THESIS BY CLECIO JOSE BORTONI DIAS

ENTITLED CREDIT CARDS, PRE-DATED CHECKS AND CONSUMER

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2- 3- 4- 5- TABLE OF CONTENTS Introduction 0.0 ccc cece ccc ccncccucccccesecccccvevceesceseseetennnecevesees 1 The Model . QC Q ĐH nh nh ng nsớ 4 The Consumer Choice between PDC and Credit Cards 31

The Choice between Credit Cards and PDC in Brazil: Empirical Results 37 Buyer’s Credibility and the Choice of Recourse (Sopranzetti’s Paradox) 52

o4) 10: Tá d4 56

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1 Introduction

Credit cards have never been popular in Brazil Up until June of 1994, inflation rates were very high, variable and, to a great extent, unpredictable It was practically impossible for firms to wait for the 30 days grace period that is normally given on credit card purchases Due to the unpredictability of the inflation rate, adjusting the price was also not a viable option In order to compensate for the lack of a viable short-term consumer credit instrument, stores began to agree to wait a specific number of days before depositing checks that were used on purchases These arrangements were known as Pre-Dated Checks (PDC)', and gradually became a national institution

The use of PDC presented two important advantages over credit cards, especially in the context of a nearly hyperinflationary process:

1) PDC allowed for more flexibility with regard to payment schedules This flexibility was especially important in a period in which a one-week grace period could represent a significant discount

2) The number of consumers with checking accounts exceeded by far that of holders of credit cards This ready availability is, in part, a consequence of the PDC flexibility Since there was little acceptance of credit cards, they did not have a great appeal to customers

As inflation rates came down", another explanation had to be found for the persistent popularity of PDC

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kept the spread between savings and borrowing rates very high The use of PDC was a way to avoid payment of financial operation taxes charged on credit card operations Even though credit cards and PDC perform nearly the same function in the economy, they are not perfect substitutes From the seller’s point of view, there is a major difference in the way the risk of default by the customer is borne In credit card sales, the risk is automatically transferred to the card administrator For purchases paid with PDC, it stays with the seller It is natural to assume then that the seller’s preference of medium of payment would be a function of her information the customer’s creditworthiness

As the popularity of PDC increased, so did the market for purchases and sales of PDC themselves Instead of waiting for the PDC to mature, storeowners would sell them to a factor, at a discount, and cash the money immediately

Factoring companies are firms that specialize in the purchase and management of accounts receivable Firms engage in business with factors mainly for two reasons: to make capital advances, and to reduce risk exposure" In Brazil, firms that factor their PDC can do so only with the purpose of advancing capital If the check is not honoured, they are responsible for reimbursing the factor for the loss

The goals of this research are the following:

1) To analyse the role of information asymmetries in the choice between the use of PDC and credit cards

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3) To correct and extend Sopranzetti’s (1998) factoring model, upon which this dissertation is based

This dissertation is organized as follows:

In chapter 2, we create a simple economic model with asymmetric information in order to analyze the seller’s preference for different types of factoring options (and, thus, for the medium of payment)

In chapter 3, we focus on the consumer’s choice of medium of payment and formulate a model combining the seller and customer’s preferences As a consequence, we observe the existence of reinforcing mechanisms that might explain the prevalence of PDC or credit cards in specific sectors of the economy

In chapter 4, we test some of the hypotheses raised in the two previous chapters against data collected in Brazil We observe strong evidence of information-based explanations for the sellers’ preference of medium of payment and some qualitative evidence of the presence or reinforcing mechanisms determining the prevalence of PDC or credit cards in specific sectors of the economy

The model presented in chapter 2 is an extension of Sopranzetti (1998) In chapter 5, we correct some errors in Sopranzetti’s analysis, and offer an alternative explanation for his empirical findings

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2 The Model

In order to analyze the consumer credit market in Brazil, we present an asymmetric information economy with three types of agents: consumers, sellers and factors

The model presented here is based on Sopranzetti’s (1998) analysis of the factoring market in the US That model, in turn, is an extension of Gorton and Pennacchi (1995), originally created for the analysis of loan sales In Sopranzetti’s model, the seller’s monitoring leve! was considered private information Here, we extend that idea by also making the factor’s level of monitoring private information As a consequence, the design of the factoring contract is the result of efforts to overcome moral hazard problems of both parties Another departure from the original model is that sellers are distinguished by different levels of internal capital costs

Those extensions will allow us to correct some errors in Sopranzetti’s analysis, while keeping all of its major results Those results were derived from empirical observations of the American factoring market Therefore, keeping them in our model is an important step towards generality

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The chapter is divided as follows: Sections 2.1-2.3 present the model characteristics, the game and the factoring contract Sections 2.4-2.6 present the main facts Section 2.7 discusses the effects not having totally creditworthy sellers in the model Section 2.8 presents the full information solution, and the comparison between that and the one of the original model Section 2.9 discusses the consequences of having factors with different capital costs Section 2.10 examines the meaning of recourse factoring

2.1 Model Description

2.1.1 Agents, Endowments and Preferences

There are three types of agents in the economy: Buyers, sellers and factors

e Buyers want to purchase one unit of a good in period 0 In exchange, they promise to pay the seller L monetary units in period ' This payment, however, is not certain We will assume that the probability of payment will be a function of the buyer’s creditworthiness c, and of how much monitoring effort the seller and the factor spend on the buyer Different levels of creditworthiness distinguish buyers

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e Factors specialize in the purchase and management of accounts receivable Their discount rates fall in between that of the two types of sellers (y,<¥<y) Like sellers, factors can also monitor buyers and the expected value of payment will increase with the amount of monitoring m exerted by the factor Monitoring the buyer at a level m will cost the factor wen All agents are assumed to be risk neutral and to maximize expected incomes

2.1.2 Information Asymmetries

The level c and m of monitoring are assumed to be private information for the seller and the factor, respectively

2.1.3 The Characteristics of the Promised Payment

Let x be a random variable representing the expected value of the payment promised by the buyer to the seller We assume that x is an increasing function of a, c and m We also assume that «x is strictly concave with regard to those three variables;

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® x increases at a decreasing rate with @ Since x is bounded between 0 and L, we restrict Z such that œ€ [I.=} In the limit, as @ goes to infinity (the buyer is perfectly creditworthy), x=L and monitoring is irrelevant

e The relative efficiency of c and m — monitoring by the seller and the factor - is regulated by # and 6, the rates at which x converges to L as c and m, respectively,

increase

2.2 The Game

The game is structured as follows:

1) The buyer applies for consumer credit with a seller

2) The seller observes &, and approaches a factor in order to offer him a factoring contract for the accounts receivable to be generated by the sale The contract specifies:

® Apnce

® A time provision, i e., whether payment will be made as soon as the contract is signed or upon maturity of the receivable

e A recourse provision

3) The factor observes o and the contract characteristics, and decides whether or not to accept the offer If he does so, he also decides how much monitoring m he will perform

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2.3 The Contract

2.3.1 Contract Characteristics

If a factoring contract is established between the seller and the factor, it will have to specify the time of payment (Maturity) and whether the factor will be able to call upon the seller for payment in case the buyer defaults on his promised payment (Recourse)

With regard to time, factoring payment can be made as soon as the contract is signed and the receivable factored (advance factoring) Alternatively, it can be made once the receivable matures (maturity factoring) We shall observe that the sellers’ internal capital costs play a major role in determining the choice between two types of contract

The recourse provision determines whether it is the seller or the factor who ultimately bears the defaults In no-recourse contracts, the factor bears the loss One can interpret that type of contract as if the factor bought the risk together with the receivable In recourse contracts, the seller bears the loss The price of the receivable will, of course, vary according to the recourse provision

The same line of thought can be applied to the time provision in the factoring business In advance factoring, the factor buys the necessary wait for the maturity time together with the receivable Thus, those are the two variables that are traded in a factoring contract: Time and Risk.‘

2.3.2 The Optimal Factoring Contract

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rational and incentive compatible for both the seller and the factor In other words, profits must be non-negative and the agents must have the proper incentives to act according to their private information

Let R be the seller’s expected profit, F the factor’s expected profit and P the price offered by for the receivable The optimal contract can be described by the following equations: 2) RÑ(P,c.m.!,2)“ maxYDP-ry,[Ê(ŒL- x(œ,c.m))+ue| ¡= hịl P.c.m.l.Z S.T @ F`(P,c.m.1,ÿ)= 7, [x(@,c,m) + ¢(L— x(a,c,m)) - wm] (Factor’s IR) —¥i P20

(4) Reo (Seller’s IR)

(5) Mm = Arg max F (Factor’s IC) (6) C = Arg max R (Seller’s IC)

where / represents an index for the time provision (/=1 for advance factoring, /=0 for maturity factoring) and ¢, an index for the recourse provision (C=0 for no recourse and C=1 for recourse contracts)

By varying / and ¢ we can observe the following types of contracts: e I=1, C=0 — Advance factoring without recourse;

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e [=0, C=0— Maturity factoring without recourse and

e I[=0, C=1 — Maturity factoring with recourse, equivalent, equivalent to no factoring at all

Notice that P is not a function of c or m Since the level of monitoring by the factor and the seller are private information, the price paid by the receivable cannot depend on those variables

Before we proceed with the analysis using the chosen functional form for x, we can establish some facts regarding the choice of advance or maturity contracts by buyers according to their discount rates We also establish the relation between the choice of recourse provision in the contract and the monitoring efforts exerted by the seller and the factor It is important to notice that many of the facts are fairly general and independent of the functional form chosen for the expected value of the receivable As a general rule, if a fact is dependent on the functional form, it will be apparent in the proof

Fact 1 - Low discount rate sellers will always opt for maturity contracts High discount rate sellers will always opt for advance contracts

Proof - We start by observing that the choice of I does not affect the seller’s IC constraint (5) Since the structure of the game guarantees that the sellers IR will be met with equality, we can solve it for P and substitute it into the maximization problem:

() R=maxr”

Pram yi [xt O(L-x)-wm]-y,[¢(L-x)t+uc] i=h,l

By substituting /=1 and 1=0 into (7), we have respectively:

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(9) R= max/.[x-wm-uc] i=hl

Prem

It is easy to observe that, for 7,<¥, (8)>(9), and that the inverse is true for 4> 7

2.4 The Recourse Provision and the Monitoring Efforts by

the Seller and Factor

From the general maximization problem, we can also establish the relationship between the recourse provisions in the factoring contract and the monitoring efforts exerted by the seller and the factor

Fact 2 - In no-recourse contracts (C=0), c will also be equal to zero, i.e., the seller will exert no monitoring effort

Proof -By substituting C=0 into (6), the seller’s IC constraint, we have:

(10) = max R(c)=y""P-yuc i=Al

c

The partial derivative of (10) with respect to c is equal to —y,u <0 Thus, in order to maximize R, the seller will choose c=0

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Fact 3- In recourse contracts (C=1), m will be equal to zero, i.e., the factor will exert no monitoring effort

Proof - By substituting C=1 into the factor’s [C constraint (5), we have:

(1U max Fn) =y,[L-wm]-yP 20

The partial derivative of (11) w.r.t m is equal to — y,w <0 Thus, in order to maximize F, the factor will choose m=0

Again, we can observe intuitively that, in recourse contracts, the factor has no incentive to monitor In case of default, he can recur to the seller for payment He will therefore maximize expected earnings by not exerting any monitoring efforts

We can now solve the maximization problem for the advance and maturity factoring cases, and to perform some comparative static analysis

2.5 Advance Factoring

Fact one has established that only high discount rate sellers will opt for advance factoring Facing a consumer credit application from the buyer, the seller will compare the expected profits for recourse and no-recourse contracts

In order to analyse the considerations that will influence the seller’s decision, we can now

- Be-dm

e

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2.5.1 Advance, no-Recourse Factoring

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2.5.2 Advance, Recourse Factoring

For /=1 and C=1, we have the following maximization problem: -& R =maxP-? -e Pvc S.T

F=e ?L-P>0 (Factor’s IR)

Since the factors IR will be met with equality, we can solve it for P, substitute it into R The first order condition for c then yields:

The solution for the maximization problem (Raa) will be given by:

d3 Rp,=r,b- |5-z"()

2.5.3 The Choice between Recourse and no-Recourse Factoring for High Discount Rate Sellers

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w w wa@ H u ua

Proof: We obtain (14) by simply subtracting (13) from (12)

From (14), we can perform some comparative static analysis We observe that the choice of the recourse provision will depend on the relative costs (u/8)and (w/d) of monitoring by the seller and the factor, respectively For instance, the first derivative of (14) with respect to (u/A) is equal to:

ee

au/B) of | <°

In words, whenever the relative cost of monitoring by the seller decreases, he will tend to favor recourse factoring The opposite will be true for the relative cost of

monitoring (w/d) by the factor Whenever w/d decreases, the seller leans towards no- recourse factoring

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2.6 Maturity Factoring

Low discount rate sellers will only sign maturity factoring contracts We now compare the expected returns for the seller for recourse and no-recourse factoring, in order to determine in which way the variables of the model will affect her decision between one choice and the other

2.6.1 Maturity, no-Recourse Factoring

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w w wa

as) R NRM 71 Ũ “5 Bin 2)

2.6.2 Advance, Maturity Factoring (No Factoring)

If the low discount rate seller decides to keep her accounts receivable, then her expected income will be the solution to the following problem (/=0,¢=1): R _ Le™ | = max”,| P- +uc Pic a S.T F= L-P20 (Factor’s IR)

Since the factors IR will be met with equality, we can solve it for P, substitute it into R The first order condition for c then yields:

The solution for the maximization problem (Raa) will be given by:

ua

H

2.6.3 The Choice between Recourse and no-Recourse Factoring for Low Discount

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Fact 5 — Given the chosen functional form, low discount rate sellers will choose recourse over no-recourse factoring if:

w WwW wa H u ua

Proof: Similar to Fact 4

Just as in the advance factoring case, relative efficiency in monitoring between the seller and the factor determines the choice between recourse and no-recourse factoring However, in this case the seller is not borrowing money from the factor As a consequence, discount rates have no influence on the decision taken by the seller

2.7 On the Implicit Assumption of Limited Borrowing by the

Seller

After observing the results of our model, one could pose the following question: Since high discount rate sellers are assumed to repay their debts with certainty, why don’t they simply borrow enough money from factors such as to bring their discount rate to the same level of factors, and then behave like low discount rate sellers?

In fact, that option has only been prevented by an implicit assumption limiting the amount that could be borrowed by the seller to the face value of the receivable L

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1) Drop it altogether — High discount rate sellers would behave like low discount rate ones, and only the relative efficiencies in monitoring (u/f) and (w/d) would influence the decision of factoring receivables with or without recourse

Instead of implicitly limiting the amount that could be borrowed by the seller to L, we could explicitly assume that in case of default, she would only honor the recourse clause of the contract up until the expected value that the receivable would have for her

In order to adapt the model to this new assumption, we change the timing of the game as follows:

1) The good is sold, the receivable is factored in period 0 at a price P and a recourse provision are established”

In period 1, the factor tries to receive payment without any monitoring If there is any default, the factor will face to options:

2.1) He can spend monitoring efforts in order to maximize the expected value of the receivable (equivalent to no-recourse factoring)

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2.7.1 The Factor’s Choice of Monitoring or Reselling the Receivable

If the Factor keeps the receivable and decides to monitor, his expected profits are given by: Fup =-P+r|t-š-Em (#) And expected profit for the seller w WwW wa ¬ -

On the other hand, if the factor decides to resell the receivable to the seller, his expected profits will be given by:

F =-P+y,Q= Khu na (2)

Expected profits for the seller will be given by:

H ua

(19) R,=P-n0-we=ly, -n[t-$)-r, r Gin (2)

Fact 6 — Given the chosen functional form, if recourse contracts limit the factor’s liability to the expected value of the receivable, then contracts will have recourse clauses if:

a lS oa) a aM ee) la)

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From Fact 6, we can observe the following: The partial derivative of (20) with respect to Yn is always negative That is, if the seller’s discount rate increases (¥, decreases), she will be more inclined to opt for recourse factoring The partial derivatives of (20) with respect to (⁄) and (w/d) are, respectively, negative and positive In other words, even though the final equation is slightly more complicated, all major results from Fact 4 are preserved For simplicity, in the remainder of the text, we shall assume that facts 1 — 4 are still valid

2.8 The Full Information Solution

In order to better evaluate the loss in efficiency caused by information asymmetries in the model, we find the solution for the factoring contract when c and m are public information

We start by observing that Fact 1 is still valid under this new hypothesis Comparing with the original maximization problem, the full information one will not have the incentive compatibility constraints, since now each party in the contract can observe the amount of monitoring exerted by the other one For the purpose of Fact 1, all other equations remain the same

2.8.1 Advance Factoring

In a full information environment, the price P of the accounts receivable can be contracted as a function of m and c

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R Frac O) = max 7," P(c,m)— y,{¢(L - x(đ,c,m)) + uc] cml S.T F(ce.m1,.0)= Y,[x(@,c,m) + {(L— x(@,c,m)) — wm] - Y; P(c,m) 20 Solving the constraint for P and substituting it into the maximization problem, we have: (21) Km Alem, lLØ)= max Yn Vs x(Œ,c,m) + ¢(L—x(@,c,m)) - wm] , cmd ge —7„[£(L— x(Œ,c,m)) + uc] We can now use (21) to compare the expected profits for the seller for recourse and no-recourse contracts

For Recourse contracts (¢=1), we have:

(22) Rar ago = max yr(L— wm)— 7,[Ù — x(Œ,c,m) + wc] For no-Recourse contracts (¢=0),

(23) Ret anr (c,m) = max Y,[x(Œ,c,m) — wm]— „cu

By subtracting (23) from (22), we have (7; —ƑY,„)(L~ x(Œ,c,m)) >0, i.e., the recourse contract dominates the no-recourse one

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The F.O.C for (23) will be:

(24) ok Remy 29

dc @

0 L c-&-

(25) a tag Hwa

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Fact 7- If monitoring is public information, then high discount rate sellers will only sign recourse factoring contracts Moreover, if

re oO Fae}

then only factors will monitor If the opposite is true, only sellers will monitor

The conclusions to be drawn from the comparison between the full and the private information cases are, of course, dependent on the functional form chosen for the expected value of payment x However, some fairly general conclusions can be inferred: e If, in the full information world, the seller is expected to monitor (or to be the main

monitor), then there will be little or no loss in efficiency due to information asymmetries

e If however the system relies mainly on the factor for monitoring, then there will be considerable loss in efficiency Normally, moral hazard situations should not give rise to inefficiencies in a risk neutral economy The natural conclusion is that inefficiency arises as a consequence of the implicit assumption regarding financing restrictions by the sellers We can observe that the factor will tend to over monitor the buyer

[nlf < 0 , and expected earnings will drop accordingly f

2.8.2 Maturity Factoring

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Rep y oS) = max lr Plevm)— 11S (L— x(@,c,m)) + ue] emg S.T F(c.m.ØÐ —y, [x(.c.m) + ế(L-— x(đ,c,m))T— wm] —y;P(c,m) >0 By substituting the IR constraint into the maximization problem, we have: (28) y,(x(@,c,m) ~ uc — wm)

Notice that Gis no longer present in the maximization problem In words, if there is full information concerning the monitoring efforts by the seller and the factor, then the choice of recourse provision becomes irrelevant

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By comparing those results with the expected profits in the private information solution, we can observe that they are equivalent to (15) and (16)

2.9 Different Discount Rates for Different Types of Factors

Up until this point in the model, we have assumed the existence of one single type of factor, that signs both recourse and no-recourse contracts In the Brazilian consumer credit market, this is not the case Credit card companies perform no-recourse operations Recourse factoring is performed by so called factors of PDC

In this section we analyze the consequences of having different parameters for different types of factors Since it has been established that factors that sign recourse contracts do not monitor, we shall ignore changes in monitoring parameters 6 and w Instead, we should concentrate the consequences of having different discount rates for different types of factors

Let ¥ and y be the inverse of the discount rates for credit card companies and factors, respectively with (¥-<yg) Possible justifications for having higher discount rates for credit card companies, when compared to PDC factors, would be differences in their tax structures and lower operating costs

2.9.1 Expected Profits for Different Factoring Options

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w Ww wa ] (29) Rypa = V te lấn eal (30) Rex = rt] n r3 i=h,l 31)  1= p| 0-24 Zn 2) i=hl G2) Ray = r|r~-š-š"|5£Ì| i=h,l

2.9.2 Low Discount Rate Sellers

By substituting i=/ into (29) - (32) we observe that, so long as Yn<Vie<Ver<yi, there are no major changes in the factoring habits of low discount rate contracts Depending on relative monitoring efficiency, they will either sign maturity factoring without recourse or keep their receivables

If instead we have yn<Vre<Vi<¥r we will observe a change in pattem Now (31)>(29) and (30)>(32) In words, the low discount rate seller will, depending on relative efficiency in monitoring, either sign maturity contracts without recourse or advance contracts with recourse

2.9.3 High Discount Rate Sellers

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monitoring efficiency, high discount rate sellers will either sign advance recourse or maturity no-recourse factoring contracts

2.10 On the Meaning of Recourse Factoring — Why doesn’t Everybody Factor?

Fact 1 establishes that high discount rate sellers will always advance factor their accounts receivable, either with or without recourse Since a considerable proportion of firms in any economy would fall into that category, the proposition deserves some consideration

Mian and Smith (1992) describe the following necessary actions for the extension of consumer credit to a buyer:

19) “the credit risk of the potential account debtor must be assessed,

2) the credit granting decision (including setting credit terms) must be made, 3) the receivable must be financed until maturity,

4) the receivable must be collected and 5) the default risk must be borne.”

In order to maximize its expected profits, a firm may decide to assign part or all of those tasks to an third party

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From table I, we observe that, among the five required actions for performing a credit sale, advance recourse factors only perform the financing of the accounts receivable and the credit collection Our model concentrates, only on time and risk issues, thus ignoring the credit collection aspect

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3 The Consumer Choice between PDC and Credit Cards

From Chapter 2, the following statement can be derived Sellers’ preferences for payment with PDC or CC are a function of the amount of information available regarding the buyer’s creditworthiness, and the transaction and capital costs attached to PDC and CC

In this chapter, we present the possible determinants of consumers’ preferences between PDC and CC We do so in order to discuss the possible resulting equilibria

3.1 Determinants of the Consumers Choice

3.1.1 Price

Both PDC and credit cards have fixed and variable costs attached to their use In order to keep a checking account in Brazil, some banks charge an annual fee, or require a minimum balance Banks also charge a certain amount per check issued

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That price structured is justified by the costs involved in check and credit card transactions It is estimated that processing a check payment, from printing to rediscounting, costs R$1.20 to the financial system Electronic transactions, on the other hand, cost R$0.20

As a consequence, for a particular customer, the relative advantage of credit cards use should increase with the number of transactions per year

3.1.2 Indirect Costs

As shall be discussed in the next chapter, there are reasons for firms to prefer one type of credit instrument or another

In the limit, some firms might simply not accept the credit instrument that is not preferred by them In less extreme cases, if a firm has a specific preference for payment with credit cards or PDC, it might give its customers economic incentives toward the use of one or the other Thus, consumers will find it convenient to use PDC, credit cards or both for their credit purchases in accordance with their purchasing habits and the mix of stores they patronize There is thus a network externality in the use of payments media: The more widely and willingly a medium is accepted, the more useful it is for a customer to carry it

3.1.3 Availability

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for purchases paid with credit cards they issue Banks hold no responsibility for purchases paid with PDC

Another reason to think that more people would hold checks that credit cards is that one needs the former in order to make payments for the latter

3.1.4 Alternative Uses for Checks and Credit Cards

Even if we do not consider economic incentives given by firms to consumers, checks and credit cards are obviously not perfect substitutes

Besides its use as a credit instrument, checks are also used for immediate payments Many employees and professionals need to hold a checking account in order to receive payments In that case, checks come as a side-benefit It is important however, to stress the fact that, in Brazil, one loses the right to issue checks against those accounts if he/she does not honor his/her checks None of those characteristics are present in credit cards

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3.1.5 Uncertainty in Income and the Choice between Credit Cards and PDC

Before accepting a PDC, Brazilian firms will often consult screening companies to check on the potential customer credit history Those will have updated records of bounced checks, cancelled checks, protested tittles and unpaid credit card bills As a consequence, if a customer defaults on his credit card payments, he will not only lose the right to use that card, but will not be able to issue PDC either

The reverse situation does not happen When a customer applies for a credit card, the company will screen his credit history However, once the card is issued, the subsequent credit behaviour of the customer (not including his credit card payments, of course), will not affect his credit line with that particular credit card company anymore So long as he does keep paying the bills for that specific card, he will get to keep that line of credit

In other words, defaulting on payment of credit card bills will imply in the loss of the right to issue PDC, but the opposite will not happen

Given that situation, one would expect that, if someone suffered a sudden reduction in income, and had to choose between honouring PDC or credit card bills, he

ự

would opt for paying his credit card bil

3.2 Equilibria

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components”) and those, like scale economies, which depend on the relative frequency with which the medium of payment is used in the economy at large (“network components”) Even though the distinctions could get blurry, we could divide, among the factors listed in section 3.1, price, indirect costs and availability as network components and alternative uses aad uncertainty in income as idiosyncratic components

For simplicity, let us suppose that these two components are additively separable Then for a particular transaction a check will be used if the total of the idiosyncratic and network components of costs for both parties from using a check are less than the total of idiosyncratic and network components of the costs of using a credit card Only the totals for the two parties matters in the choice: if both parties agree that the credit card is cheaper to use, then clearly the credit card will be used If there is disagreement, then a negotiation between the two parties, together with a possible adjustment in the price paid, will generally lead to the choice which minimizes total costs of making the payment arrangements