Why Credit Bureaus? Information Asymmetry (Pt. 2)

This is part of a larger series on Credit Bureaus and Access to Finance. I recommend reading the Intro if you haven’t, and then Part 1 of this mini-series if you are interested.

When lenders face challenges like moral hazard, adverse selection, and weak contract enforcement, they will do their best to mitigate them. This can take a form of screening; however, markets characterized by information asymmetry often possess high screening costs as well.[1] Credit bureaus provide one way of overcoming information asymmetry and reducing screening costs through systematically sharing credit information. By sharing credit information, bureaus can reduce adverse selection by disclosing borrower type to the lender, allowing them to price their loans appropriately, and reduce moral hazard through a discipline effect.[2] If borrowers know that lenders will share their default history with one another, it creates incentives for borrowers to repay their loans if they want to borrow in the future or avoid high interest rates.[3]

Credit bureaus are information sharing institutions. Lenders are most willing to share information when they operate in environments of extremely mobile borrowers and lack credit information on much of the population.[4] Incentives to share information also increase as credit markets deepen.[5] The first credit bureau began when merchants realized that their own personal knowledge and trust of customers was not adequate for the growing credit market.[6] After an economic crisis in the 1830s and early 40s in the United States, Lewis Tappan, a wholesaler hurt by a bad borrower, started a company called the Mercantile Agency in 1841.[7] This agency began credit reporting as we know it today and was able to report on creditworthiness of companies across the country.[8] In 1901, the Mercantile Agency, then known as RG Dun & Company, opened the first credit bureau in Africa in Cape Town, South Africa.[9]

However, lenders also have incentives to avoid information sharing. By sharing information with others, lenders allow their competitors to gain valuable information on the characteristics and credit history of their own customers.[10] This can threaten their market share. Since most lenders do not want to lose an information advantage or reduce market share, information sharing is not always an ideal solution to information asymmetry. This means that information sharing is less likely to occur in environments marked by high levels of competition.[11] Yet, even though high levels of competition between lenders decreases the incentives to share information, they will do it anyways when borrowers are likely to switch locations.[12] Hence, information sharing is most likely when the costs from adverse selection exceed the costs of losing an information advantage and strengthening competition.

However, even in situations characterized by high adverse selection, costs can still discourage information sharing. For informal moneylenders who face challenges of increasing borrower mobility and information asymmetry in their markets, sharing information is often prohibitively expensive.[13] This encourages lenders to rely on personal relationships and screening methods. Systematic credit reporting actually began before 1841 in the United States, but the reports were expensive and many businesses continued to rely on relationship lending.[14] In order for lenders to share information, the costs of sharing must be lower than the costs created from information asymmetry. The answer to the question of this post ultimately comes down to a question of scale. Rotating Savings and Credit Associations (ROSCAs), Accumulating Savings and Credit Associations (ASCRAs), Savings and Credit Cooperatives (SACCOs), other micro-finance institutions,  networks, credit cooperatives, and even notaries have been used to address issues of information asymmetry in lending. Ideally, credit bureaus and similar information sharing institutions provide information at lower costs on a scale the other forms cannot.[15]

While these two posts have been more on the theoretical side, they are important for those interested in the logic behind information sharing. For the sake of the case I make as a whole, it is important to understand the problem they attempt to solve.

[1] Marcel Fafchamps, Market Institutions in Sub-Saharan Africa: Theory and Evidence (Cambridge, Mass: MIT Press, 2004), 14; 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.

[2] Maria Soledad Martinez Peria and Sandeep Singh, The Impact of Credit Information Sharing Reforms on Firm Financing? (2014), 3; Tullio Jappelli and Marco Pagano, “Information Sharing, Lending and Defaults: Cross-Country Evidence,” Journal of Banking and Finance 26, no. 10 (2002): 2019, http://dx.doi.org/10.1016/S0378-4266(01)00185-6.

[3] A. Jorge Padilla and Marco Pagano, “Sharing Default Information as a Borrower Discipline Device,” European Economic Review 44, no. 10 (2000): 1953, http://dx.doi.org/10.1016/S0014-2921(00)00055-6; Giné, Goldberg, and Yang, 2925, 26, 28; Parikshit Ghosh and Debraj Ray, “Information and Enforcement in Informal Credit Markets,” Economica 83, no. 329 (2016): 61, http://dx.doi.org/10.1111/ecca.12169.

[4] Marco Pagano and Tullio Jappelli, “Information Sharing in Credit Markets,” The Journal of Finance 48, no. 5 (1993): 1714, http://dx.doi.org/10.1111/j.1540-6261.1993.tb05125.x; Martin Brown and Christian Zehnder, “The Emergence of Information Sharing in Credit Markets,” Journal of Financial Intermediation 19, no. 2 (2010): 256-57, http://dx.doi.org/10.1016/j.jfi.2009.03.001.

[5] Pagano and Jappelli, 1714.

[6] James H. Madison, “Evolution of Commercial Credit Reporting Agencies in Nineteenth-Century America,” Business History Review 48 (1974): 166.

[7] Ibid.

[8] Robert Cull et al., “Historical Financing of Small- and Medium-Size Enterprises,” Journal of Banking and Finance 30, no. 11 (2006): 3025, http://dx.doi.org/10.1016/j.jbankfin.2006.05.005.

[9] TransUnion, “Company History,” accessed 12/19/2016, 2016. https://www.transunion.co.za/about-us/company-history.

[10] Pagano and Jappelli, 1701.

[11] Brown and Zehnder, 257.

[12] Ibid.

[13] Ghosh and Ray, 60.

[14] Madison, 164, 166.

[15] Ghosh and Ray, 76.

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