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Lending to uncreditworthy borrowers

Rajdeep Sengupta

No 2007-044, Working Papers from Federal Reserve Bank of St. Louis

Abstract: This paper models entry and competition in "high-risk" credit markets. An incumbent lender's advantage over any outside bank derives from its knowledge of (i) the risk profile of its (creditworthy) clients and (ii) uncreditworthy types in the borrower population. Screening is costly and the uninformed lender's ability to use collateral as a screening mechanism depends on its cost advantage over its informed rival. Nevertheless, the outside bank can pool uncreditworthy borrowers with creditworthy types, but only if it has a low cost of funds. Therefore, while a secular decline in the cost of funds does not help outside banks to screen uncreditworthy borrowers, it allows them to pool these borrowers with creditworthy types. This not only facilitates entry of outside banks into "high-risk" credit markets, but also makes it optimal for them to include non-creditworthy borrowers in their loan portfolio. The framework is relevant for explaining the recent entry of outside banks into the "subprime"-end of the loan market, for example, loans to the lowest end of small businesses in developing countries - also known as microfinance.

Keywords: Credit control - United States; Bank loans - United States (search for similar items in EconPapers)
Date: 2008
New Economics Papers: this item is included in nep-ban, nep-mfd and nep-rmg
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Journal Article: Lending to uncreditworthy borrowers (2014) Downloads
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Handle: RePEc:fip:fedlwp:2007-044