Asset Price Volatility And Efficient Discrimination In Credit Market Equilibrium

Significant variation in the terms and volume of lending across classes of borrowers distinguished only by qualities independent of credit risk is often interpreted as evidence of inefficient or inequitable discrimination in credit markets. Increasing accuracy in the measure of credit risk renders common theories of lending discrimination and credit rationing based on lender preferences or asymmetric information increasingly implausible. We consider a traditional model of lending with complete markets, in which equilibria may exhibit disparate loan terms or access to credit across such classes of borrowers, despite common knowledge about the parameters describing the market. Rather than evidence of inefficient equilibria owing to discrimination, however, such equilibria can arise solely from the influence of asset price volatility on participants strategically exercising the options embedded in standard debt contracts. Extending substantially different loan terms or even rationing credit to different classes of borrowers can be a rational response by value-maximizing lenders when borrower classes are correlated with the degree of price volatility exhibited by the otherwise similar assets being financed by members of each of these classes. We discuss our results in the context of actual credit markets