Consumer credit risk and pricing.

Previous academic studies viewed borrower rejection as a sign of market imperfections in the consumer credit markets, but this view was based upon the assumption that differences in the levels of borrower creditworthiness could not be accurately identified. Today, it is possible to differentiate

between types of borrowers, and riskier borrowers can participate in credit markets if they are willing to pay relatively higher borrowing costs. Hence, a more critical issue concerning the performance of these markets should be whether loan prices correctly reflect the level of borrower credit risk. This paper reexamines consumer participation in credit markets looking specifically at issues related to the pricing of borrowers of different credit risk.

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While an extensive academic literature examines the problem of limited household credit access, consumer credit use has increased significantly for almost two decades. During the late 1980s, researchers such as Luckett (1986) and Canner, Fergus, and Luckett (1988) were already discussing the various innovations in consumer credit markets that made it easier for consumers to finance their expenditures with credit. Automated credit scoring, the growth of asset securitization, and more flexible underwriting standards have encouraged greater competition among lenders to supply credit during the 1990s. Several years of robust economic growth have also stimulated the demand for all forms of credit. Although both supply and demand factors have led to rising mortgage, automobile, and revolving debts, substantially more research has been conducted on consumer credit constraints, while surprisingly very little attention has been given to the increase in credit access.

This paper reexamines issues related to consumer credit market participation. Due to the lack of available repayment information, previous empirical studies could not distinguish between high- and low-risk borrowers and treated all rejected borrowers as "credit constrained." Moreover, the conventional wisdom view suggested that borrowers faced credit constraints because lenders did not have enough information to correctly assess credit risk. However, lenders do have information concerning borrower repayment history that can be used to price credit risk. The 1998 and 2001 Surveys of Consumer Finances (SCFs) also now include questions that can distinguish between differences in household credit quality.(1) Therefore, the first objective of this research is to investigate whether high-credit risk households do in fact account for most credit denials. If borrowers who traditionally would have been considered credit constrained are shown to lack creditworthiness based upon their observable loan repayment histories, then these rejections are not indicative of credit market inefficiencies.