The cost of better information: risk-based pricing and aggregate default

David C. Webb

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: In credit markets where borrower types are observable, is it welfare-maximizing for a rate-setting institution to offer different rates to different borrower types, or to pool them at a common rate? Moral hazard favors separation; deadweight default costs favor pooling, since compressing rates reduces aggregate defaults through hazard rate heterogeneity. We derive the condition determining which force dominates: the ratio of default cost intensity to moral hazard intensity. We show that there is a single threshold value of this ratio such that separation strictly dominates below it, complete pooling strictly dominates above it, and the two are welfare-equivalent exactly at it, for every possible value of the ratio. The result does not depend on information being scarce: even though borrower types are observable throughout, pooling can still dominate separation when default costs are sufficiently large, provided the maintained compression and effort conditions we state precisely continue to hold; we conjecture, but do not formally establish, that the same logic extends to imperfect information if the threshold, recomputed for that weaker information structure, continues to be exceeded. The welfare criterion is utilitarian surplus; the efficiency claim is surplus maximization, not Pareto improvement.

Keywords: debt contracts; default costs; pooling; separation; moral hazard (search for similar items in EconPapers)
JEL-codes: D82 D86 G21 G28 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2026-09-24
References: Add references at CitEc
Citations:

Published in Review of Finance, 24, September, 2026. ISSN: 1572-3097

Downloads: (external link)
https://researchonline.lse.ac.uk/id/eprint/140893/ Open access version. (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:140893

Access Statistics for this paper

More papers in LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library LSE Library Portugal Street London, WC2A 2HD, U.K.. Contact information at EDIRC.
Bibliographic data for series maintained by LSERO Manager ().