Credit Cards, Race, and Entrepreneurship

We use the decision by 14 states to remove credit card interest rate caps after the U.S. Supreme Court's 1978 Marquette decision as a natural experiment to explore the impact of credit card availability on black entrepreneurship. Using self-employment as a measure of entrepreneurship, we use Current Population Survey data from 1971-1985 to show that removing state-level rate caps led to increases in self-employment among black individuals. We verify this pattern using Survey of Consumer Finance data from 1977-1986 and find additional evidence that credit cards may have enabled black entrepreneurs to overcome financial discrimination and access needed capital. * The authors would like to thank William Darity, J. P. Eggers, David Mowery, Ramana Nanda, Gabriel Natividad, Alicia Robb, Jason Snyder, Victor Stango, Catherine Wolfram, Jonathan Zinman, and participants in seminars at the UC Berkeley Haas School of Business, Duke University Law School, NYU Stern School of Business, and American Economic Association annual meeting for thoughtful comments. The authors also thank Chris Knittel and Victor Stango for generously sharing data on state banking characteristics and Randall Kroszner and Philip Strahan for generously sharing data on state banking laws. Credit Cards, Race, and Entrepreneurship 2 The role of liquidity constraints in entrepreneurial financing has presented a persistent puzzle for scholars. While several prior academic studies have explored the importance of liquidity constraints for entrepreneurs, they yield contradictory results. For example, David G. Blanchflower and Andrew J. Oswald (1998), Robert Fairlie (1999), Thomas Lindh and Henry Ohlsson (1996), and Ramana Nanda (2009) all demonstrate that wealth constraints hinder entrepreneurship and that shocks that remove these constraints lead to higher entrepreneurship. Erik Hurst and Annamaria Lusardi (2004) and Mitchell A. Peterson and Rajan G. Raghuram, (2002), on the other hand, argue that wealth constraints are likely small. In particular, Hurst and Lusardi (2004) find that the probability of entering self employment is broadly similar across most of the wealth distribution. It may be possible to shed light on these contradictory results if scholars explore the relative importance of different types of financing for different types of entrepreneurs. For example, prior research has shown that black entrepreneurs have a harder time obtaining financing than white entrepreneurs. This difficultly appears to be driven in part by racial discrimination when applying for loans (Robert Fairlie and Alicia Robb, 2008). However, there is also evidence that black entrepreneurs might be more likely to finance their ventures using credit cards than white entrepreneurs, presumably because of differences in their ability to access credit cards versus traditional bank loans (Fairlie and Robb, 2008). Our paper investigates whether credit cards, which eliminate the need for face-to-face interactions with a loan officer, are a mechanism that black entrepreneurs use to overcome business financing frictions arising from discrimination. We accomplish this by evaluating the impact of state-level credit card interest rate caps on black transitions into entrepreneurship in the United States. Exogenous variation in state-level interest rate caps was created by the Marquette decision, a 1978 Supreme Court ruling that effectively eliminated state-level caps on credit card Credit Cards, Race, and Entrepreneurship 3 interest rates for a group of states over several years. A number of states eliminated caps after the decision, allowing credit card companies in those states to charge much higher rates and extend credit to more borrowers. We focus on the elimination of credit card interest rate caps and show that eliminating caps increased black transitions into self-employment. These results are consistent across two different data sets. Furthermore, we show that black individuals who owned credit cards in states without caps were more likely to be self-employed, that blacks in states with a history of racial discrimination were more likely to enter self-employment after caps were eliminated, and that eliminating caps had a much larger effect on black transitions into entrepreneurship than other types of bank deregulation in the same period. These findings suggest that black individuals faced discrimination-based barriers to entrepreneurship in the 1970s and 1980s and used credit cards as a mechanism to overcome those barriers. Prior work has found that blacks generally enter entrepreneurship at lower rates than whites (Robert W. Fairlie, 1999). Several explanations have been offered to explain this disparity, including family structure (Michael Hout and Harvey S. Rosen, 2000), liquidity constraints, and consumer discrimination (Bruce D. Meyer, 1990). Even after becoming entrepreneurs, black individuals face more challenges in running a successful business. Alicia M. Robb, Robert W. Fairlie and David T. Robinson (2009) show that black entrepreneurs have more trouble accessing external capital markets, and rely more heavily on owner financing. David G. Blanchflower, Phillip B. Levine and David J. Zimmerman (2003) find that black-owned small businesses are more likely to be denied bank credit than other groups, and when they do obtain credit, they pay higher interest rates. Other work (George J. Borjas and Stephen G. Bronars, 1989; Meyer, 1990; Daiji Kawaguchi, 2005) has suggested that consumer discrimination may decrease returns for black entrepreneurs. Enrichetta Ravina (2008) studies an online lending Credit Cards, Race, and Entrepreneurship 4 market and finds that, while black borrowers are as likely to obtain a loan as white borrowers, black borrowers pay significantly more basis points than white borrowers even though delinquency rates are similar. The literature examining black individuals and entrepreneurship indicates that blacks may have less access than whites to credit through standard lending channels. In an appendix, we confirm this empirical finding using data from on black borrowers in the 1970s and 1980s. However, the goal of this article is to understand the response of black entrepreneurs to these frictions. Our argument is that when the Marquette decision removed interest rate caps and credit card availability increased, black individuals may have been more likely than whites to use credit cards as a mechanism to finance entrepreneurial entry. While previous work has explained the dynamics of competition between credit card companies (Victor Stango, 2002; Victor Stango 2003), no published paper to our knowledge has systematically addressed the impact of credit cards on entrepreneurship. This is in sharp contrast to other forms of financing such as venture capital, which has received significant attention in the literature (David Hsu, 2004) but which is rarely available to small business entrepreneurs. In the next section, we discuss the Marquette decision. Section II describes our methods and data. Section III describes the main results: that black individuals were more likely to transition into self-employment if they resided in a state that eliminated its credit card interest rate cap. Section III also provides additional results showing how discrimination affected lending patterns, and how black individuals used credit cards to overcome that discrimination. Section IV concludes and discusses the implications of our analysis. Credit Cards, Race, and Entrepreneurship 5 I. The Marquette Decision In December 1978, the Supreme Court considered the case of Marquette National Bank of Minneapolis v. First Omaha Service Corp. The case centered around First Omaha’s marketing of credit cards to Minnesota customers. During this period, states were allowed to set their own caps on credit card interest rates, so First Omaha was charging a higher rate (as allowed by Nebraska law) than Minnesota-based banks could offer to customers in their own state. As a result, the Minnesota attorney general contended that these activities interfered with the state’s ability to enforce its usury laws (Diane Ellis, 1998). The Court ruled that the National Bank Act stipulated that banks could charge the highest allowable rate in their home state, regardless of the interest rate cap in the customer’s state of residence (Lawrence M. Ausubel, 1997; Ellis, 1998). Starting in 1980, and particularly in 1981, a number of states removed credit card interest rate caps (see Figure 1; New Hampshire was the one state that had no cap for the entire period). Note that the removal of interest rate caps did not immediately follow the Supreme Court ruling in December 1978, but instead occurred over a four year period from 1980 – 1983. According to some accounts, states removed interest rate caps in an attempt to attract and retain banks, and major banks like Citibank moved to high rate or no limit states such as South Dakota (Ausubel, 1997; Ellis, 1998). However, despite Citibank’s high profile move to South Dakota, there was not an immediate migration to no limit states because of legal restrictions on interstate banking. Many of these restrictions remained in place until the mid-1980s (Randall S. Kroszner and Philip E. Strahan, 1999). As a result, there was not an immediate saturation of interstate credit cards marketed from banks in no limit states to individuals in states with limits. Individuals living in states that eliminated interest rate caps were immediately affected, but not individuals residing in Credit Cards, Race, and Entrepreneurship 6 states with limits. In fact, Christopher R. Knittel and Victor Stango (2003) report that, as of 1984, only 8 to 9 percent of customers with incomes above $15,000 held out-of-state bank cards. Following Marquette, credit card lending has increased and banks have extended more credit to high risk borrowers, since they can compensate for increased risk of default with higher rates of interest (W. F. Baxter, 1985; Ellis, 1998). Bringing together the past literature on financing entrepreneurship, including liquidity constraints, the role of credit cards, and the specific challenges faced by black entrepreneurs, we expect that black entrepreneurship increased after the state removes its credit card interest rate cap following the Marquette decision, as more black individuals were given access to credit to finance entrepreneurial ventures. We test this proposition using two different data sets and information on credit card interest rates from before and after the state removed its credit card interest rate cap. The only other paper that uses the Marquette decision as a natural experiment is unpublished work by Jonathan Zinman (2002), which uses the Marquette decision to study changes in consumer use of credit cards with data from the Federal Reserve Board’s Survey of Consumer Finance (SCF). The emphasis in Zinman’s paper is the change in credit card use following the Marquette decision. We view Zinman’s work as complementary to ours because he shows that individuals are more likely to have a credit card post-Marquette. II. Data and Empirical Strategy We hypothesize that access to credit cards is an important determinant of entrepreneurial activity. Our prediction is that removing state level credit card interest rate caps will lead to increased entrepreneurship, and that this effect will be especially pronounced among blacks. We Credit Cards, Race, and Entrepreneurship 7 treat these state-level changes in credit card interest rates as exogenous and use them to proxy for changes in the availability of credit card financing. Raw data confirm that state-level changes in credit card interest rates affected the type of capital: individuals living in states with no limit on the allowable interest rate paid a statistically significantly greater APR on their outstanding balances. In addition, according to the SCF and as shown in Zinman (2002), there was a higher percentage of credit card ownership in no-limit states: by 1986, 73 percent of individuals living in limit states owned a credit card, compared to 80 percent of individuals living in no-limit states. Finally, we use data on the state-level HHI of credit card companies to show that HHI levels are lower in states with no limit on credit card interest rates. While this result is not statistically significant, it suggests that there is a greater supply of credit cards in no limit states. The goal of our empirical strategy is to take advantage of the state-level changes in maximum credit card interest rates brought about by the Marquette decision to explain transitions into selfemployment and black self-employment, while controlling for other individual characteristics. More specifically, we use a difference-in-difference approach to compare self-employment in states that eliminate credit card interest rate caps to self-employment in states that do not eliminate caps. Data on the interest rate cap for each state during our sample period was hand-collected from annual volumes of The Cost of Personal Borrowing in the United States. Figure 1 shows that the number of states with no limits increased from one to fourteen following the 1978 1 The 1983 Survey of Consumer Finances contains data on self reported credit card APRs. Based on data from 1699 individuals, we can reject the null hypothesis that the credit card APR is the same in no limit states as in other states at the 99 percent confidence level. 2 This data was generously provided by Christopher Knittel and Victor Stango. 3 An alternate strategy would compare black transitions into self-employment before and after the December 1978 Marquette decision. We have verified that the basic results hold under this alternative strategy. Credit Cards, Race, and Entrepreneurship 8 Marquette decision. We use two surveys of individual characteristics and employment for our analysis. We first use the Current Population Survey (CPS) data from 1971-1975, 1977-1981, and 1983-1985 to establish the link between changes in the maximum allowable credit card interest rate and self-employment rates. The CPS is ideal for this analysis because it includes many variables that we use to control for alternative explanations. We then use the Survey of Consumer Finances (SCF) data from 1977, 1983, and 1986 to investigate credit card ownership patterns and evidence of discrimination. Both the CPS and SCF data cover the periods before and after the Marquette decision. However, the SCF data does not include information from all states. The SCF is the only data source we could find that predates the Marquette decision and has information on credit card use; however, the SCF has few annual observations. The CPS data has many annual observations, but lacks personal financial information. Hence, we use data from both surveys, making every effort to collect similar individual characteristics across the two surveys. We restrict our observations in both surveys to individuals who are between ages 18 and 65, who work full time, and who do not work for the military or on a farm. Consistent with other work in this area (Fairlie, 1999), transition into self-employment is our dependent variable in all regressions. Self-employment is commonly used to identify entrepreneurs, and is the best variable we have given the nature of the CPS data. We identify transitions into self-employment by restricting the sample to individuals who were employed full time in a wage-paying job in the prior year. We also collect a number of individual characteristics that previous studies have 4 CPS does not have data for 1976 and 1982. SCF does not have data for 1978-1982 or 1984-1985. 5 SCF data does not include information from the following states: DC, HI, ID, KS, MD, MT, ND, NH, NM, NV, RI, VT, WV and WY. 6 It would be interesting to distinguish between self-employed individuals who work in a single-person firm and self-employed individuals who employ others. Nanda (2009) has a dataset that allows him to perform such a study, but we are unaware of any U.S. dataset that pre-dates the Marquette decision. Credit Cards, Race, and Entrepreneurship 9 shown are important predictors of self-employment. These variables include indicators for black, female, married, home owner, urban, high school graduate and low-income (indicating a household income in the bottom 20 percentile) as well as continuous variables for age and its square. Several studies have found that interstate banking deregulation led to increases in entrepreneurship (Sandra E. Black and Philip E. Strahan, 2002; Nicola Cetorelli and Philip E. Strahan, 2006; William R. Kerr and Ramana Nanda, 2009). We include four dummy variables indicating whether the state passed any banking deregulation that could affect the availability of credit. These variables are dummies for deregulation of intrastate branching through M&A (merger restrictions), full intrastate branching (unit branching), interstate bank branching (interstate branching), and multi-state holding companies (holding company). The CPS and SCF data differ in several ways. With the CPS data, we construct demographic variables by location for unemployment and farm population. From the SCF we use demographics at the county level which were collected from the 1980 census. Demographic variables are county unemployment rate and county farm population. For the SCF, individuals in the “high income” sample are excluded because the SCF does not include geographic identifiers for these individuals and we cannot map them to a state. The CPS data includes various weights. However, similar to Manju Puri and David T. Robinson (2009), we do not use weights in any of the reported results because our intent is to measure the effect of changes in credit card 7 The results are robust to the exclusion of homeowner and income, the two variables that are most at risk of being endogenous to the self-employment decision. 8 The data on these deregulations were generously provided by Kroszner and Strahan. 9 We use the same county demographic values for each year in our sample, and because of the lack of county identification in the 1977 SCF, we aggregate county-level information to the primary sampling unit (PSU) level. Credit Cards, Race, and Entrepreneurship 10 regulation on an individual’s decision to become an entrepreneur. Table 1 presents summary statistics of all variables used. The main specification is: (1) transition into self-employmentimt = α + λm + TIMEt + βnolimitnolimitmt + βblack*nolimitblack*nolimitimt + Ximtβ + eimt Ximt is a vector of individual characteristics (including a dummy for black), county demographics and state banking deregulations. The actual covariates depend on the survey used, and are described in more detail below. We include market (λm) and year (TIMEt) fixed effects. Market is defined differently across regressions, but in most cases is at the metropolitan-state level. For all regressions, we use the variable no limit to indicate whether the individual is located in a state that has no limit on credit card interest rates. We expect that individuals who live in states that remove interest rate caps are more likely to transition into self-employment, and so we expect βnolimit to be positive. We expect that black individuals who live in states that remove interest rate caps will be even more likely to transition into self-employment, and so we expect βblack*nolimit to be positive.