Ebook The Size of Credit Bureaus with Multiple Lender Relationship
It is well known, that the extension of credit is problematic due to asymmetric information between borrowers and lenders. Such informational problems have an adverse effect on the efficient allocation of credit and on the access to financial resources, especially in the small business and consumer markets. Lenders are often unable to observe borrower characteristics, the riskiness of their investment projects, which induces adverse selection problems.
Credit information sharing addresses precisely these fundamental problems. In many countries, however, information sharing includes only a small part of the lending industry or it does not exist at all. In other countries shared information is more pervasive.
The purpose of our work is to explore the incomplete nature of information sharing. By focusing on private information sharing mechanisms based on reciprocity principle. Why is information sharing is incomplete? What are the factors underlying the coverage information sharing? To the best of our knowledge, this problem has not been discussed in the existing literature. We determine the factors that support the pervasiveness of information exchange, help to expand its coverage, and thereby decrease cost of credit for creditworthy borrowers.
To provide answers to these questions, we study a banking competition model with 2 periods. In the first period period, a number of banks compete for a population of high and low ability borrowers who sign multiple loan contracts to finance one project (”partial loans”). At this stage, competition is based on symmetric information about the proportion and success chances of the high and low ability borrowers. Once borrowers make repayments, each bank observes it for its own borrowers. While it is harder to conclude borrower’s type based on partial loan repayments, banks may share information forming a ”consortium” in the second period, and conclude more accurately on borrower’s type.
In deciding the optimal number of members in the consortium, the monopolistic credit bureau is maximizing per-member profit. We find, that this optimization by bureau members results in less than full coverage of all lenders. This result is due to the decreasing added information by subsequent members. When the consortium is already large enough, existing members may be able to conclude on types with high enough precision. And although further members may add some information, it may not be sufficient to make up for their profit share in the consortium.
The decreasing returns to information puts an upper bound on the size of the consortium. We show that as borrowers sign more contracts in the first period, optimal consortium size grows in the second period. The reason why this happens is the following; as borrowers choose more lenders, they take smaller loans from each of them. Then, because smaller loans can be returned by low ability borrowers with higher probability, returning this amount provides less information about borrower’s type it is less obvious for the bureau whether the borrower’s success was due to her high ability, or due to her luck. As a result, the credit bureau finds it optimal to include more members to identify borrower types better.
Furthermore, the size is decreasing in borrower heterogeneity: as borrowers become increasingly similar, it is harder and harder to distinguish them, and so more and more information is necessary to conclude about types. On the other hand, it is increasing in the proportion of high ability borrowers. That is, if the population is safer on average, defaults occur less often, so that further banks may be needed to find more defaults.
Borrowers’ decision to sign multiple contracts arises endogenously. High ability borrowers find it beneficial to sign multiple loan contracts. By doing so in the first period, they increase their chances of being served by a group of lenders who will create a consortium in the second period. Repayments in the consortium will improve members’ beliefs about her type, and therefore, will give her a loan at a lower interest rate in the second period. Assuming absence of any screening devices, low ability borrowers mimic, and receive similar partial loans.
The consortium is formed through exchange of information between homogeneous lenders of equal size. Whenever its size is less than full coverage of the banking industry, it still extracts monopoly profits while competing with the separate outside lenders; As a group, the consortium has more information about each borrower, and therefore faces less adverse selection and lower costs of extending credit.
We go on to discuss the implications for asymmetric bank structure, allowing for a dominant in the economy. Such an analysis allows to explain many observed phenomena in the credit bureau industry around the world. For example with a large enough dominant bank, our model sheds light on why the bank may not find it profitable to exchange information with other banks, or with an existing consortium. Such instances have been observed in Hungary and Russia, where the major players do not agree to share their database with the country’s credit bureau, that consolidate’s borrower database on most of the economy.
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