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Lending to Uncreditworthy Borrowers

We study optimal lending behavior under adverse selection in environments with hetero- geneous borrowers— specifically, where the borrower’s reservation payoffs (outside options) increase with quality (creditworthiness). Our results show that factors affecting credit sup- ply can also affect lending standards either directly through lending costs or indirectly through borrower reservation payoffs. Lending to uncreditworthy borrowers can be pre- vented by lowering reservation payoffs, by raising lending costs, or both. Lenders seeking to attract creditworthy borrowers with high reservation payoffs would have to lower rates and, consequently, increase collateral requirements on offers that screen out uncreditworthy types. This leads to higher screening costs, thereby increasing the profitability of offers that pool uncreditworthy borrowers— a veritable lowering of credit standards. In addition, equilibria in a competition version of the model can also explain the phenomenon of “cream-skimming” by outside (foreign) lenders. Surprisingly, we find that the presence of an informed rival actually aids “cream-skimming” behavior.

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