research

Working Papers

Adverse Selection and Learning in Consumer Credit Markets (joint with Charles R. Smith)

Abstract: This paper highlights a trade-off in credit markets between regulatory safeguards for informed consent and the informational frictions they can amplify. We find that requiring banks to garner explicit consent prior to raising clients' credit limits leads to riskier borrowers disproportionately consenting. This introduces a new form of adverse selection. In response, we find banks decreased the size of the average credit limit increase and simultaneously gave more frequent limit increases. We develop a precautionary savings model with endogenous credit limits to study the role of learning and adverse selection in markets with incomplete information. We show that learning from acceptance decisions can rationalize our empirical results. Our model suggests that requiring consumer consent reduced lender profits but had negligible effects for consumers. Our counterfactuals demonstrate that under contractionary monetary policy requiring consumer consent would decrease both the frequency and size of limit increases.