research

Working Papers

Adverse Selection and Learning in Consumer Credit Markets (joint with Charles R. Smith)

Abstract: This paper highlights a trade-off in credit markets between regulatory safeguards for informed consent and the informational frictions they can amplify. In our empirical setting, we find that requiring lenders to garner explicit consent prior to raising clients' credit limits induces adverse selection. We find disproportionately higher take-up among riskier borrowers, as measured by increased utilization, delinquency, and charge-offs, which worsens the risk profile of accounts that receive a credit limit increase. In response to the policy, we find that lenders decreased the size of credit limit increases, yet simultaneously gave more frequent limit increases. We develop a model of lender credit limit provision to study the role of adverse selection and learning. We show that learning from acceptance decisions can rationalize lenders' increased frequency of credit limit increases, while adverse selection can rationalize the decline in the size of credit limit increases.