Leland and Rubinstein (1976) first show that an optional asymmetric performance structure can be reached using some portfolio insurance strategies. Thanks to dynamic allocation strategies, insured portfolios are protected against large falls by a contractually guaranteed predetermined floor and they take partially advantage of market performances. A portfolio insurance trading strategy is defined to guarantee a minimum level of wealth at a specified time horizon, and to participate in the potential gains of a reference portfolio (Grossman and Villa, 1989; Basak, 2002).
It is well known that lenders use credit scores to regulate the extension of consumer credit. People with high scores are offered credit on more favorable terms. People who default on their loans experience a decline in their scores and, therefore, lose access to credit on favorable terms. People who run up debt also experience a decline in their credit scores and have to pay higher interest rates on new loans. While credit scores play an important role in the allocation of consumer credit they have not been adequately studied in the consumption smoothing literature. This paper attempts to remedy this gap.
We propose a theory of unsecured consumer credit where: borrowers have the legal option to default;defaulters are not exogenously excluded from future borrowing; there is free entry of lenders; and lenders cannot collude to punish defaulters. In our framework, limited credit or credit at higher interest rates following default arises from the lender’s optimal response to limited information about the agent’s type and earnings realizations. The lender learns from an individual’s borrowing and repayment behavior about his type and encapsulates his reputation for not defaulting in a credit score. Our underlying framework is broadly consistent with the way real-world unsecured consumer credit markets work. The framework can be used to shed light on household consumption smoothing with respect to transitory income shocks and to examine the welfare consequences of legal restrictions on the length of time adverse events can remain on one’s credit record.
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