A Quantitative Theory of Information and Unsecured Credit (Revised July 2011)

Over the past three decades six striking features of aggregates in the unsecured credit market have been documented: (1) rising personal bankruptcy rates, (2) rising dispersion in unsecured interest rates across borrowing households, (3) the emergence of a discount for borrowers with good credit ratings, (4) a reduction in average interest rates paid by borrowers, (5) an increase in aggregate debt relative to income, and (6) an increase in the amount of debt discharged in bankruptcy relative to income. The main contribution of this paper is to suggest that improvements in the ability of lenders to observe borrower characteristics can help account for a substantial proportion of most, though not all, of these observations. A central aspect of our findings is that the power of signaling is likely to be weaker when it is non-pecuniary costs, rather than the persistent component of income, that are unobservable. The ex ante welfare gains from better information are positive but small