Credit risk, regulatory costs and lending discrimination in efficient residential mortgage markets

Significant differences in loan terms between demographically distinct groups of borrowers in the United States are often interpreted as evidence of systematic ethnic, racial or gender discrimination by lenders. The appearance and interpretation of such discrimination has long been a controversial issue in public policy and has significant implications for both the economic efficiency and equity of credit markets. Arising from concern for borrowers disadvantaged by such discrimination, the design and implementation of regulations preventing the disparate treatment of demographically distinct groups by lenders are generally considered to have enhanced the equality of access to credit. Unfortunately, existing research has not examined whether this gain in social equity comes at a cost in efficiency borne by all market participants. The reliance on adverse selection or moral hazard in current models of limited lending and credit rationing poses difficulties in empirical testing for the presence and magnitude of such costs. This paper offers a novel theoretical framework in which lending discrimination can endogenously arise in the presence of value-maximizing lenders competing in an economy with complete markets, common knowledge and arbitrage-free pricing. By avoiding the reliance of current models on the exogenous presence of adverse selection or moral hazard, this framework allows potential efficiency costs to beexamined in a market environment without an ex ante assumption of informational market failure. Owing to the presence of common knowledge among participants, we first show how equilibrium loan terms to borrowers in different demographic classes can diverge in such an efficient environment. We then apply the properties exhibited in market equilibria to measure the potential costs of misallocating credit risk owing to the type of regulations observed in actual credit markets.