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Lending to Uncreditworthy Borrowers
How might a low lending costs prompt lenders to include uncreditworthy borrowers in their portfolio? This paper presents a theoretical study into how lender competition can affect borrower quality, especially in a low interest rate setting. I study equilibria where lenders compete aggressively by poaching on rivals’ clients. Poaching is impeded because rivals not only have superior information about the quality of existing (creditworthy) clients but also uncreditworthy types in the borrower population. Screening is costly, and the uninformed lender’s ability to use collateral as a screening mechanism depends on its cost advantage over its informed rival (i.e., relative levels of lending costs). Importantly, the uninformed lender can pool uncreditworthy borrowers with creditworthy types in low interest rate settings (i.e., for low absolute level of lending cost). Therefore, while a secular decline in lending costs leaves the uninformed lender’s ability to screen uncreditworthy borrowers unchanged, it opens the opportunity for them to pool these borrowers with creditworthy types. This not only facilitates entry of outside lenders into “high-risk” credit markets, but also makes it optimal for them to poach borrowers from rivals by including uncreditworthy borrowers in their loan portfolio. Equilibrium lending behavior in this setting can also explain the phenomenon of cream-skimming on entry by outside (foreign) lenders.