A Recursive Equilibrium Model with Credit Scoring and Competitive Pricing of Default Risk
نویسندگان
چکیده
This paper explores how consumption smoothing (via borrowing and lending) works when a person cannot commit to payback a loan. We study an environment where individuals are of two types, with one type having a higher propensity to default on debt obligations. Financial intermediaries cannot directly observe a person’s type but make probabilistic assessments of it based on the person’s credit history. We interpret the probability assigned to a person not being of the type that defaults more frequently as the person’s credit score. In a recursive competitive equilibrium, the terms of credit offered by financial intermediaries depend only on the person’s credit score, the amount of credit requested and the risk-free rate. Furthermore, a person’s choice of how much to borrow or lend, along with the current score, determines the person’s future credit score. Thus, the framework delivers an integrated theory of the terms of credit and the credit score. The theory seems capable of explaining some features of the data.
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