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Observing unobservables: identifying information asymmetries with a consumer-credit field experiment

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Author Info
Dean Karlan
Jonathan Zinman

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Abstract

Information asymmetries are important in theory but difficult to identify in practice. We estimate the empirical importance of adverse selection and moral hazard in a consumer credit market using a new field experiment methodology derived from theoretical models. We randomized 58,000 direct mail offers issued by a major South African lender along three dimensions: 1) the initial "offer interest rate" appearing on the direct mail solicitations; 2) a "contract interest rate" equal to or less than the offer interest rate and revealed to the over 4,000 borrowers who agreed to the initial offer rate; and 3) a dynamic repayment incentive that extends preferential pricing on future loans to borrowers who remain in good standing. These three randomizations, combined with complete knowledge of the Lender's information set, permit identification of specific types of private information problems. Specifically, our setup distinguishes adverse selection from moral hazard effects on repayment, and thereby generates unique evidence on the existence and magnitudes of specific credit market failures. We find some evidence of both adverse selection and moral hazard, and the findings suggest that about 40% of default is due to asymmetric information problems. This helps explain the prevalence of credit rationing even in a market that specializes in financing high-risk borrowers at very high rates.

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Article provided by Federal Reserve Bank of Chicago in its journal Proceedings.

Volume (Year): (2005)
Issue (Month): Apr ()
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Handle: RePEc:fip:fedhpr:y:2005:i:apr:x:12

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Keywords: Consumer credit Loans

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. de Meza, David & Webb, David C, 2001. "Advantageous Selection in Insurance Markets," RAND Journal of Economics, The RAND Corporation, vol. 32(2), pages 249-62, Summer.
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  2. Gale, William G., 1990. "Federal lending and the market for credit," Journal of Public Economics, Elsevier, vol. 42(2), pages 177-193, July. [Downloadable!] (restricted)
  3. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Blackwell Publishing, vol. 48(2), pages 289-309, April. [Downloadable!] (restricted)
  4. Pierre-Andre Chiappori & Bernard Salanie, 2001. "Testing for Asymmetric Information in Insurance Markets," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 56-78, February. [Downloadable!] (restricted)
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  5. Chiappori, Pierre Andre & Salanie, Bernard, 2002. "Testing Contract Theory: A Survey of Some Recent Work," CESifo Working Paper Series CESifo Working Paper No. , CESifo GmbH. [Downloadable!]
  6. Dilip Mookherjee & Debraj Ray, 2002. "Contractual Structure and Wealth Accumulation," American Economic Review, American Economic Association, vol. 92(4), pages 818-849, September. [Downloadable!]
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  7. Elyasiani, Elyas & Goldberg, Lawrence G., 2004. "Relationship lending: a survey of the literature," Journal of Economics and Business, Elsevier, vol. 56(4), pages 315-330. [Downloadable!] (restricted)
  8. Amy Finkelstein & Kathleen McGarry, 2003. "Private Information and its Effect on Market Equilibrium: New Evidence from Long-Term Care Insurance," NBER Working Papers 9957, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  9. Bernanke, Ben & Gertler, Mark, 1990. "Financial Fragility and Economic Performance," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 87-114, February. [Downloadable!] (restricted)
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  10. Ausubel, Lawrence M, 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, American Economic Association, vol. 81(1), pages 50-81, March.
  11. Wendy Edelberg, 2004. "Testing for adverse selection and moral hazard in consumer loan markets," Finance and Economics Discussion Series 2004-09, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  12. Amy Finkelstein & Kathleen McGarry, 2006. "Multiple Dimensions of Private Information: Evidence from the Long-Term Care Insurance Market," American Economic Review, American Economic Association, vol. 96(4), pages 938-958, September. [Downloadable!]
  13. Morduch, Jonathan, 1994. "Poverty and Vulnerability," American Economic Review, American Economic Association, vol. 84(2), pages 221-25, May. [Downloadable!] (restricted)
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  14. R. Glenn Hubbard, 1998. "Capital-Market Imperfections and Investment," Journal of Economic Literature, American Economic Association, vol. 36(1), pages 193-225, March. [Downloadable!] (restricted)
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  15. Paul S. Calem & Loretta J. Mester, 1995. "Consumer behavior and the stickiness of credit card interest rates," Working Papers 95-10, Federal Reserve Bank of Philadelphia.
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  16. Banerjee, Abhijit & Duflo, Esther, 2004. "Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program," CEPR Discussion Papers 4681, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  18. Erik Hurst & Annamaria Lusardi, 2004. "Liquidity Constraints, Household Wealth, and Entrepreneurship," Journal of Political Economy, University of Chicago Press, vol. 112(2), pages 319-347, April. [Downloadable!] (restricted)
  19. Nava Ashaf & Dean Karlan & Wesley Yin, 2004. "Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines," Natural Field Experiments 0007, The Field Experiments Website. [Downloadable!]
  20. Nidhiya Menon, 2004. "Consumption Smoothing in Micro Credit Programs," Development and Comp Systems 0403005, EconWPA. [Downloadable!]
  21. Dean Karlan & Jonathan Zinman, 2005. "Elasticities of Demand for Consumer Credit," Working Papers 926, Economic Growth Center, Yale University. [Downloadable!]
  22. Karlan, Dean S., 2007. "Social Connections and Group Banking," CEPR Discussion Papers 6194, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  23. Kevane, Michael & Wydick, Bruce, 2001. "Microenterprise Lending to Female Entrepreneurs: Sacrificing Economic Growth for Poverty Alleviation?," World Development, Elsevier, vol. 29(7), pages 1225-1236, July. [Downloadable!] (restricted)
  24. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June. [Downloadable!] (restricted)
  25. Bester,Helmut Hellwig,Martin, 1987. "Moral hazard and equilibrium credit rationing: An overview of the issues," Discussion Paper Serie A 125, University of Bonn, Germany.
  26. Nava Ashraf & Dean Karlan & Wesley Yin, 2006. "Tying Odysseus to the Mast: Evidence from a Commitment Savings Product in the Philippines," The Quarterly Journal of Economics, MIT Press, vol. 121(2), pages 635-672, May. [Downloadable!] (restricted)
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  27. Banerjee, Abhijit V & Newman, Andrew F, 1993. "Occupational Choice and the Process of Development," Journal of Political Economy, University of Chicago Press, vol. 101(2), pages 274-98, April. [Downloadable!] (restricted)
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  28. Mark M. Pitt & Shahidur R. Khandker, 1998. "The Impact of Group-Based Credit Programs on Poor Households in Bangladesh: Does the Gender of Participants Matter?," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 958-996, October. [Downloadable!] (restricted)
  29. Brad M. Barber & Terrance Odean, 2001. "Boys Will Be Boys: Gender, Overconfidence, And Common Stock Investment," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 261-292, February. [Downloadable!] (restricted)
  30. Cardon, James H & Hendel, Igal, 2001. "Asymmetric Information in Health Insurance: Evidence from the National Medical Expenditure Survey," RAND Journal of Economics, The RAND Corporation, vol. 32(3), pages 408-27, Autumn.
  31. de Meza, David & Webb, David, 2000. "Does credit rationing imply insufficient lending?," Journal of Public Economics, Elsevier, vol. 78(3), pages 215-234, November. [Downloadable!] (restricted)
  32. Bruce Shearer, 2004. "Piece Rates, Fixed Wages and Incentives: Evidence from a Field Experiment," Review of Economic Studies, Blackwell Publishing, vol. 71(2), pages 513-534, 04. [Downloadable!] (restricted)
  33. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Nava Ashraf & Dean Karlan & Wesley Yin, 2006. "Deposit Collectors," Advances in Economic Analysis & Policy, Berkeley Electronic Press, vol. 6(2), pages 1483-1483. [Downloadable!] (restricted)
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  2. Marianne Bertrand & Dean S. Karlan & Sendhil Mullainathan & Eldar Shafir & Jonathan Zinman, 2005. "What's Psychology Worth? A Field Experiment in the Consumer Credit Market," Working Papers 918, Economic Growth Center, Yale University. [Downloadable!]
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  3. Dean Karlan & Jonathan Zinman, 2007. "Expanding Credit Access: Using Randomized Supply Decisions to Estimate the Impacts," Working Papers 956, Economic Growth Center, Yale University. [Downloadable!]
  4. Karlan, Dean S. & Zinman, Jonathan, 2007. "Expanding Credit Access: Using Randomized Supply Decisions to Estimate the Impacts," CEPR Discussion Papers 6407, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  5. Dean Karlan & Xavier Gine & Jonathan Morduch & Pamela Jakiela, 2006. "Microfinance Games," Working Papers 936, Economic Growth Center, Yale University. [Downloadable!]
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  6. Amy Finkelstein & James Poterba, 2006. "Testing for Adverse Selection with "Unused Observables"," NBER Working Papers 12112, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. William Adams & Liran Einav & Jonathan Levin, 2007. "Liquidity Constraints and Imperfect Information in Subprime Lending," NBER Working Papers 13067, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Cull, Robert & Demirguc-Kunt, Asli & Morduch, Jonathan, 2006. "Financial performance and outreach : a global analysis of leading microbanks," Policy Research Working Paper Series 3827, The World Bank. [Downloadable!]
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  9. Giné, Xavier & Karlan, Dean S., 2007. "Group versus Individual Liability: A Field Experiment in the Philippines," CEPR Discussion Papers 6193, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  10. Dean S. Karlan, 2005. "Using Experimental Economics to Measure Social Capital and Predict Financial Decisions," American Economic Review, American Economic Association, vol. 95(5), pages 1688-1699, December. [Downloadable!]
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  11. Nava Ashraf & James Berry & Jesse M. Shapiro, 2007. "Can Higher Prices Stimulate Product Use? Evidence from a Field Experiment in Zambia," NBER Working Papers 13247, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Karlan, Dean S. & Zinman, Jonathan, 2007. "Credit Elasticities in Less-Developed Economies: Implications for Microfinance," CEPR Discussion Papers 6071, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  13. Dean Karlan & Jonathan Zinman, 2005. "Elasticities of Demand for Consumer Credit," Working Papers 926, Economic Growth Center, Yale University. [Downloadable!]
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