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Loans, Insurance and Failures in the Credit Market for Students

Elena Del Rey () and Bertrand Verheyden

No 359, Working Papers from Barcelona Graduate School of Economics

Abstract: Whereas public student loans are often income contingent, private banks typically offer pure loans, or don't offer loans at all. In order to provide a rationale for these observations, we present a model with perfectly competitive banks and risk averse students who have private information on their ability to learn. We show that the combination of ex-post moral hazard and adverse selection produces credit market rationing when default penalties are low. Intermediate levels of default penalties can result in the existence of an equilibrium that pools together ability types. However, pooling contracts are not insuring at equilibrium, which implies a second type of credit market failure. Finally, if default penalties are large enough, equilibrium contracts provide less able students with insurance against the eventuality of a bad outcome, just in the income contingent loan fashion. The model is also used to explain other stylized facts, such as the positive impact of returns to education and interest rate subsidies on the development of the student loan market. Also, it explains why, unlike banks, governments oer income contingent loans.

Keywords: ex-post moral hazard; adverse selection; income contingent loans (search for similar items in EconPapers)
JEL-codes: D82 I22 (search for similar items in EconPapers)
Date: 2008-08
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