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Working Paper 2007-044C

"Lending to Uncreditworthy Borrowers"
by Rajdeep Sengupta

How might a low cost of funds prompt lenders to include uncreditworthy borrowers in their loan portfolio? This paper presents a theoretical study into how lender competition can affect borrower quality, especially when the cost of funds is low. I study equilibria in credit markets where lenders poach on borrowers in a bid to gain market share. An incumbent’s advantage over any outside lender stems from its knowledge of (i) the risk profile of its (creditworthy) clients and (ii) uncreditworthy types in the borrower population. Screening is costly, and the uninformed lender’s ability to use collateral as a screening mechanism depends on its cost advantage over its informed rival. Nevertheless, the outside lender can pool uncreditworthy borrowers with creditworthy types, but only if it has a low cost of funds. Therefore, while a secular decline in the cost of funds leaves the uninformed lender’s ability to screen uncreditworthy borrowers unchanged, it opens the opportunity for them to pool these borrowers with creditworthy types. This not only facilitates entry of outside lenders into high-risk credit markets, but also makes it optimal for them to poach borrowers from rivals by including uncreditworthy borrowers in their loan portfolio. Appendix

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Category > Finance
Category > Banking
Author > Rajdeep Sengupta
Research Papers and Publications: JEL Code > G21
Research Papers and Publications: JEL Code > D43