Costly Screening, Self-Selection, Fraud, and the Organization of Credit Markets

Abstract

This paper analyzes a credit market that includes a costly, universal and imperfect screening technology with both type I and type II errors and borrower self-selection. Universal screening is necessary because there are fraudulent borrowers. These characteristics, which have been omitted from other models, make it more representative of actual mortgage and consumer lending conditions. Contrary to the results in previous models with random screening, the combination of universal screening and type I screening error produces a pooling equilibrium as a non-trivial outcome. This result suggests that generalized lenders can sometimes compete with specialized lenders serving a single borrower type in credit markets that rely on costly lender screening. At other times pooling lenders will not be competitive and this, by itself, could lead to periodic waves of failure. These theoretical results appear to have implications for stability in markets for consumer credit.

Keywords: credit supply, screening, separating equilibrium, pooling equilibrium

JEL Classification: D82, D86, G20, L16