Academic journal article The Journal of Consumer Affairs

Consumer Credit Risk and Pricing

Academic journal article The Journal of Consumer Affairs

Consumer Credit Risk and Pricing

Article excerpt

Previous academic studies viewed borrower rejection as a sign of market imperfections in the consumer credit markets, but this view was based upon the assumption that differences in the levels of borrower creditworthiness could not be accurately identified. Today, it is possible to differentiate between types of borrowers, and riskier borrowers can participate in credit markets if they are willing to pay relatively higher borrowing costs. Hence, a more critical issue concerning the performance of these markets should be whether loan prices correctly reflect the level of borrower credit risk. This paper reexamines consumer participation in credit markets looking specifically at issues related to the pricing of borrowers of different credit risk.

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While an extensive academic literature examines the problem of limited household credit access, consumer credit use has increased significantly for almost two decades. During the late 1980s, researchers such as Luckett (1986) and Canner, Fergus, and Luckett (1988) were already discussing the various innovations in consumer credit markets that made it easier for consumers to finance their expenditures with credit. Automated credit scoring, the growth of asset securitization, and more flexible underwriting standards have encouraged greater competition among lenders to supply credit during the 1990s. Several years of robust economic growth have also stimulated the demand for all forms of credit. Although both supply and demand factors have led to rising mortgage, automobile, and revolving debts, substantially more research has been conducted on consumer credit constraints, while surprisingly very little attention has been given to the increase in credit access.

This paper reexamines issues related to consumer credit market participation. Due to the lack of available repayment information, previous empirical studies could not distinguish between high- and low-risk borrowers and treated all rejected borrowers as "credit constrained." Moreover, the conventional wisdom view suggested that borrowers faced credit constraints because lenders did not have enough information to correctly assess credit risk. However, lenders do have information concerning borrower repayment history that can be used to price credit risk. The 1998 and 2001 Surveys of Consumer Finances (SCFs) also now include questions that can distinguish between differences in household credit quality.(1) Therefore, the first objective of this research is to investigate whether high-credit risk households do in fact account for most credit denials. If borrowers who traditionally would have been considered credit constrained are shown to lack creditworthiness based upon their observable loan repayment histories, then these rejections are not indicative of credit market inefficiencies.

A second objective of this research is to gain more insight into the pricing patterns of loans in consumer credit markets. Rather than face rejection, high-risk households can participate in credit markets if they are willing to pay higher rates to compensate lenders for the additional risk. However, some borrowers having different levels of credit risk pay similar costs, and vice versa. If borrowers of high and low credit quality pay similar prices for credit or, conversely, borrowers with very similar credit quality characteristics obtain a wide range of credit prices and terms, then such findings may serve as better indicators of consumer credit market failures possibly arising from discrimination and/or predatory lending. For this reason, credit pricing is a more relevant issue today than credit rejection.

LITERATURE REVIEW

A large literature has tested for capital market imperfections by seeking evidence that households face liquidity or credit constraints. Research studies, such as Jappelli (1990), Canner, Gabriel, and Woolley (1991), Cox and Jappelli (1993), and Duca and Rosenthal (1993), have relied on questions from the 1983 SCF. …

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