Dissertation/Thesis Abstract

Costly Screening and the Market Structure of Consumer Credit
by Yu, Pingkang, Ph.D., The George Washington University, 2012, 184; 3527464
Abstract (Summary)

There is a significant theoretical literature about the nature of equilibrium in consumer credit markets. The prevailing conclusion of these models is that a pooling equilibrium across borrower risk types is unlikely to be a market equilibrium. Instead, borrowers will be segregated and self-select and the resulting separating equilibrium will have specialized lenders for different risk types.

The theoretical exercises in this dissertation differ from previous literature in four major ways: 1) considering both type I and type II errors in underwriting applicants; 2) including fraudulent applicants who have no intention of repaying; 3) considering differences in both underwriting costs and credit risks among applicants; 4) modeling screening as being universal instead of random. Under these alternative, realistic assumptions, the theoretical model developed in this study demonstrates that in a credit market where borrowers self-select and lender's screening is costly, a pooling equilibrium can arise as a result of the high cost of screening, the possibility of both type I and II errors in the process, and the threat of fraudulent applicants which prompts universal screening.

Then an expanded model is developed by adding a distinctive type of borrower who has low credit risk but high underwriting cost. The model presents a simple but powerful two-dimensional framework that incorporates both credit risk and screening cost in analyzing the equilibrium structure of credit markets. The model establishes several key results: 1) the only possible pooling equilibriums in the market are pooling with non-risk based pricing; 2) the low-risk-high-screening-cost borrowers can only be pooled with borrowers of higher risks; 3) only the pooling equilibriums in which the lender conducts minimum screening to eliminate liars are stable in the long run; 4) a host of short-run pooling equilibriums can exist in which lenders do not screen at all, which creates a channel through which fraudulent borrowers can enter and eventually destroy the non-screening pooling equilibriums in the credit market. The theory demonstrates that screening cost is a key factor that determines the credit market structure, as well as a key element for evaluating the prospect of any financial innovations.

Finally, an empirical exercise confirms the implications of the theory for the way in which market structure changes in response to falling screening cost. Using a loan level database covering a substantial share of outstanding mortgages in the US, the empirical test exploits a natural experiment embedded in the comparison of low-documentation loans originated by different types of lenders in the time period that covers the 2007 subprime mortgage crisis.

Indexing (document details)
Advisor: Yezer, Anthony Marvin
Commitee: Boulier, Bryan, Carrillo, Paul, Joshi, Sumit
School: The George Washington University
Department: Economics
School Location: United States -- District of Columbia
Source: DAI-A 74/02(E), Dissertation Abstracts International
Subjects: Economics, Finance, Economic theory
Keywords: Consumer credit, Costly screening, Market structure, Mortgage, Pooling equilibrium, Screening cost
Publication Number: 3527464
ISBN: 9781267617897
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