Implications of Optimal Price Regulation in Sub-Prime Banking Markets

Abstract

This paper investigates a model of endogenous product differentiation in subprime lending markets. In the subprime literature the discussion surrounds two competing hypotheses about pricing behavior. The opportunity pricing hypothesis suggests that lenders are rent seeking in their pricing behavior. On the other hand, the efficient pricing hypothesis suggests that the higher interest rates observed is simply lenders' compensation for the increased risk inherent in sub-prime loans. The paper accomplishes a number of goals by being an authentic formal model of sub-prime lending behavior. It formally addresses increasing returns to scale (IRS), Variable Annual Percentage Rates (APRs), product differentiation and risks. The main finding of this paper is that when the efficient pricing hypothesis is imposed in the form of an average cost pricing rule, banks will maximally differentiate their product. However, high quality-type banks benefit from increased market power, while low quality-type banks could benefit from either increased market share, or increased market power.

Keywords: Sub-Prime Lending, Efficient Pricing Hypothesis, Opportunity Pricing Hypothesis, Financial Crisis, Bank Competition

JEL Classification: G00, G01, G10, G18, G20, G21, G28