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Measuring the Welfare Cost of Asymmetric Information in Consumer Credit Markets

Journal: Journal of Financial Economics

Date: 20221201

Author: DeFusco, Anthony A.; Tang, Huan; Yannelis, Constantine

Abstract:
Information asymmetries are known in theory to lead to inefficiently low credit provision, yet empirical estimates of the resulting welfare losses are scarce. This paper leverages a randomized experiment conducted by a large fintech lender to estimate welfare losses arising from asymmetric information in the market for online consumer credit. Building on methods from the insurance literature, we show how exogenous variation in interest rates can be used to estimate borrower demand and lender cost curves and recover implied welfare losses. While asymmetric information generates large equilibrium price distortions, we find only small overall welfare losses, particularly for high-credit-score borrowers.

Link: Google Scholar

Key Findings

Large Price Distortion

Asymmetric information leads to equilibrium interest rates that are 22 percentage points higher than efficient levels (30.4% vs 8.5%)

Small Welfare Loss

Despite high price distortion, overall welfare loss is only 0.8% of loan amount (~¥50 or $7.20 per applicant) due to inelastic demand

Credit Score Impact

Welfare losses are 4x larger for low credit score borrowers (1.7%) compared to high credit score borrowers (0.4%)

Interest Rate Effects on Take-up and Charge-offs

  • Low-Price group (21.5% interest) had 65% take-up rate vs 58% for High-Price group (36% interest)
  • High-Price group had 13% charge-off rate vs 11% for Low-Price group
  • Results indicate presence of asymmetric information - higher rates attract riskier borrowers

Equilibrium vs Efficient Outcomes

  • Competitive equilibrium interest rate (30.4%) is substantially higher than efficient rate (8.5%)
  • Despite large price difference, equilibrium quantity (60.8%) is only 10 percentage points lower than efficient quantity (70.3%)
  • Small quantity effect due to inelastic borrower demand (elasticity of -0.13)

Credit Score Heterogeneity

  • Welfare losses are 1.7% of loan amount for low credit score borrowers (Rating 2-4)
  • Welfare losses are only 0.4% for high credit score borrowers (Rating 1)
  • Interest rate sensitivity of charge-offs is 2x higher for low credit score borrowers

Contribution and Implications

  • First study to quantify welfare costs of asymmetric information in fintech lending market
  • Develops methodology to measure welfare losses in credit markets that can be applied broadly
  • Small welfare losses suggest limited role for policy interventions like interest rate subsidies or loan guarantees
  • Results specific to Chinese fintech market - welfare costs could differ in other credit markets

Data Sources

  • Take-up and charge-off rates from Figure 2 showing experimental results across treatment groups
  • Equilibrium and efficient outcomes calculated from demand and cost estimates in Table 2
  • Credit score heterogeneity analysis based on Table 3 comparing outcomes across rating categories