Emergence of Captive Finance Companies and Risk Segmentation in Loan Markets: Theory and Evidence

By Barron, John M.; Chong, Byung-Uk et al. | Journal of Money, Credit & Banking, February 2008 | Go to article overview

Emergence of Captive Finance Companies and Risk Segmentation in Loan Markets: Theory and Evidence


Barron, John M., Chong, Byung-Uk, Staten, Michael E., Journal of Money, Credit & Banking


THIS PAPER PRESENTS a theoretical model and empirical evidence of risk segmentation of the secured consumer installment loan market by two different types of lending institutions--independent lending institutions and captive finance companies. A consumer installment loan is a credit arrangement repaid through periodic installment payments over a specific length of time. in general, consumer installment loans are used for financing the purchase of expensive durable goods. The good purchased serves as collateral for collection on borrower's default. Captive finance companies are the subsidiaries that finance the sales of products of their parent manufacturers. (1)

Several empirical papers have examined market segmentation issues related to finance companies. Boczar (1978) empirically studied the risk segmentation of consumer loan markets on the basis of borrower risk characteristics. Data from a national survey of households are used to determine socioeconomic and life-cycle characteristics of borrowers at banks and finance companies. Boczar finds substantial overlap in borrower risk characteristics for the sampled households.

Remolona and Wulfekuhler (1992) examine the differential performances of banks and finance companies in credit markets. They find that, in consumer loan markets, finance companies lost market share to banks and their affiliates. On the other hand, growth occurred for finance companies in market segments for relatively risky credit, where command of specialized information was critical to lending institutions.

Carey, Post, and Sharpe (1998) empirically examine the existence of specialization in the private corporate loan market, extending the research on the public versus private debt distinctions. Comparing corporate loans made by commercial banks and finance companies, they find that the two types of lending institutions are equally likely to finance information-problematic firms. However, finance companies tend to serve observably high-risk borrowers. They find that both regulatory and reputation-based explanations are significant for this specialization.

Our paper differs from the above papers in its focus on the secured automobile installment loan market, a market that involves two key types of lending institutions, banks (including commercial banks, credit unions, and other depository institutions) and captive finance companies. A key feature of a captive finance company is that its credit decision takes into account not only the return from granting a "captive loan" but also the return from the sale of the product purchased with the captive loan. We develop a theoretical model that incorporates this feature, and in doing so provide an explanation for the emergence of captive finance companies as well as a prediction regarding the risk segmentation of the automobile loan market. We then provide an empirical test of our theory using a unique data set that allows us to consider the differential performance of automobile loans from the two different types of lenders.

The remainder of this paper is organized as follows. Section 1 presents a model where an independent lending institution (a "bank") obtains an imperfect but informative signal on the creditworthiness of a borrower, and makes a credit decision by setting an optimal cutoff signal. Section 2 introduces a simple model of a monopolistically competitive durable good market, assuming that consumers can obtain financing for the purchase of durable goods only from banks.

Section 3 links the analysis of Sections 1 and 2 by noting that the positive gain to the durable good seller from additional sales provides an incentive to establish a captive finance company that offers loans to individuals who would not be provided such loans by independent lenders due to their higher risk of default. In other words, the existence of positive rents for the durable good seller induces its captive finance company to set an optimal credit standard (cutoff signal) below the level of banks in equilibrium, resulting in risk segmentation of the loan market by banks and captive finance companies. …

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