A Finite-Life Private-Information Theory of Unsecured Consumer Debt
51 Pages Posted: 25 Jun 2007
Date Written: May 28, 2007
The authors present a theory of unsecured consumer debt that does not rely on utility costs of default or on enforcement mechanisms that arise in repeated-interaction settings. The theory is based on private information about a person's type and on a person's incentive to signal his type to entities other than creditors. Specifically, debtors signal their low-risk status to insurers by avoiding default in credit markets. The signal is credible because in equilibrium people who repay are more likely to be the low-risk type and so receive better insurance terms. The authors explore two different mechanisms through which repayment behavior in the credit market can be positively correlated with low-risk status in the insurance market. Their theory is motivated in part by some facts regarding the role of credit scores in consumer credit and auto insurance markets.
Keywords: Unsecured Consumer Debt, Bankruptcy, Default, Adverse Selection, Credit Score, Insurance
JEL Classification: D82, D91, G19
Suggested Citation: Suggested Citation