Why Credit Bureaus? Information Asymmetry (Pt. 1)

This is part of a larger series on Credit Bureaus, see the Introduction

What Problem are Credit Bureaus Trying to Solve?

 

Whether providing high-interest loans in informal markets, or billion dollar loans to multinational corporations, lenders everywhere face the same challenge – gaining enough information about borrowers to mitigate the risk of non-performing loans. To the lender, it is very hard to tell which businesses are likely to be successful and which ones are likely to fail, especially if there is little history or information about prospective borrowers.[1] Each lender must overcome the fundamental problem of information asymmetry – the reality that borrowers know their own odds of repaying a loan better than the lender does.[2] This includes the borrowers’ intentions, their ability to repay in normal circumstances, and their ability to repay in the event of economic hardship. Credit bureaus are one attempt at overcoming the problem of information asymmetry.

Information asymmetry creates two problems: moral hazard and adverse selection. Moral hazard is a collection of incentives for borrowers to increase their risk-taking, to put less effort into the business endeavor, or to willfully default on a loan because it is already in possession and the lender is unable to monitor the credit situation or is incapable of enforcing debt collection.[3] Adverse selection is the inability to differentiate the good and bad borrowers in a market, often resulting in good borrowers being priced out.

The incentives for moral hazard occur after the borrower receives the loan.[5] The borrower may not put forth sufficient effort in their enterprise, or may fail to repay the loan after seeing the profits from their enterprise.[6] Since they already possess the loan and do not face close monitoring, borrowers can choose how to use the funds from a loan without much fear of recourse, especially if contract enforcement is non-existent or too expensive.[7] This is one reason that lenders in informal markets will develop close relationships with their borrowers and visit the business–so they can monitor the output of the endeavor and ensure repayment.

Adverse selection arises because information asymmetry makes it harder for lenders to know whom the good and bad borrowers are. Banks can try to screen borrowers by increasing interest rates or raising collateral, but these actions will often price safe borrowers out of the market and increase the pool of risky borrowers.

Weak or expensive contract enforcement amplifies the problems of moral hazard and adverse selection. Lenders do not have to worry as much about defaulters or opportunists if impartial courts enforce contracts.[10] However, deterring cheaters will prove challenging if legal fees for enforcing contracts are expensive, if contractual obligations are vague or lacking in specific documentation, if the courts are unreliable or impotent, or if claiming collateral is challenging.[11] Lenders who know contracts are hard to enforce will then face the temptation to ration credit.[12] Credit rationing occurs when the demand for credit exceeds supply, and borrowers who are willing to either pay higher interest rates or put up increased collateral will still not receive a loan even if there are identical to borrowers who do.[13] In the presence of imperfect information, weak contract enforcement, and non-existent or irrecoverable collateral, the lender must take extra care to find good borrowers and prevent losses, even if it means lending less.

These challenges alone do not result in the creation of a credit bureau, there are specific conditions that must arise. See Part 2

 

[1] Raju Jan Singh, Kangni Kpodar, and Dhaneshwar Ghura, “Financial Deepening in the Cfa Franc Zone: The Role of Institutions,” (2010), 50.

[2] IFC, Credit Reporting Knowledge Guide (2012), 4.

[3] James A. Vercammen, “Credit Bureau Policy and Sustainable Reputation Effects in Credit Markets,” Economica 62, no. 248 (1995): 461; Parikshit Ghosh and Debraj Ray, “Information and Enforcement in Informal Credit Markets,” Economica 83, no. 329 (2016): 60, http://dx.doi.org/10.1111/ecca.12169; Xavier Giné, Jessica Goldberg, and Dean Yang, “Credit Market Consequences of Improved Personal Identification: Field Experimental Evidence from Malawi,” The American Economic Review 102, no. 6 (2012): 2923, http://dx.doi.org/10.1257/aer.102.6.2923.

[4] Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in Markets with Imperfect Information,” The American Economic Review 71, no. 3 (1981): 393, 408; Marco Pagano and Tullio Jappelli, “Information Sharing in Credit Markets,” The Journal of Finance 48, no. 5 (1993): 1694, http://dx.doi.org/10.1111/j.1540-6261.1993.tb05125.x.

[5] Marcel Fafchamps, Market Institutions in Sub-Saharan Africa: Theory and Evidence (Cambridge, Mass: MIT Press, 2004), 32.

[6] Giné, Goldberg, and Yang, 2923.

[7] Fafchamps, Market Institutions in Sub-Saharan Africa: Theory and Evidence, 32.

[8] Ghosh and Ray, 59, 60; Giné, Goldberg, and Yang, 2930.

[9]Stiglitz and Weiss, 393, 408; Pagano and Jappelli, 1694

[10] Fafchamps, Market Institutions in Sub-Saharan Africa: Theory and Evidence, 165.

[11] Ibid., 14, 165; Ghosh and Ray, 59.

[12] Simeon Djankov, Caralee McLiesh, and Andrei Shleifer, “Private Credit in 129 Countries,” Journal of Financial Economics 84, no. 2 (5// 2007): 316, http://dx.doi.org/http://dx.doi.org/10.1016/j.jfineco.2006.03.004.

[13] Stiglitz and Weiss, 408; Ghosh and Ray, 61.

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