Information Asymmetries in Consumer Credit Markets

Abstract

This paper tests for incentive and selection effects in a subprime consumer credit market. We estimate the incentive effect of loan size on default using sharp discontinuities in loan eligibility rules. This allows us to estimate the magnitude of selection from the cross-sectional correlation between loan size and default. We find evidence of advantageous incentives and adverse selection. For a given borrower, we estimate that a $100 increase in loan size decreases the probability of default by 3.7 to 4.2 percentage points, a 20 to 23 percent decrease from the mean default rate. The incentive effect is more than o ffset by adverse selection into larger loans. Borrowers who choose $100 larger loans are 6.9 to 8.0 percentage points more likely to default than borrowers who choose smaller loans. Taken together, our results are consistent with the idea that information frictions lead to credit constraints in equilibrium.