Researchers have long examined how market concentration interacts with lender screening in credit markets. The efficiency of lending markets, for example, can be hampered by information imperfections, but such harmful effects can be in part mitigated by imperfect competition. The authors propose and test a new channel through which competition can have adverse effects on consumer credit markets.
This may seem counterintuitive. How can credit market competition lead to consumer harm? Imagine that lenders can invest in a fixed-cost screening technology that screens out consumers who are likely to default, allowing lenders to charge lower interest rates to the remaining consumers. Lenders in concentrated markets have higher incentives to invest in screening, since their fixed costs are divided among a larger customer base. As a result, when market competition increases, lenders have lower incentives to invest in screening. The population of borrowers becomes riskier, and interest rates can increase, leaving consumers worse off.
The authors develop a model of competition in consumer credit markets with selection and lender monitoring, which shows that, in the presence of lender monitoring, the effect of market concentration on prices depends on the riskiness of borrowers. In markets with lower-risk borrowers, the authors find a standard classical relationship: more competition leads to lower prices. However, in markets with a greater portion of high-risk borrowers, increased competition can actually increase prices.
The authors provide empirical support for the model’s counterintuitive predictions through an examination of the auto loan market to reveal that, indeed, in markets with high-risk borrowers, increased competition is associated with higher prices.
These findings have implications for competition policy in lending markets. Competition appears not to improve market outcomes in subprime credit markets, so antitrust regulators may want to allow some amount of concentration in these markets. The authors’ results also suggest, though, that there is some degree of inefficiency in the industrial organization of these markets: firms appear to make screening decisions independently, even though there are returns to scale in screening. Better outcomes are possible at lower costs if firms could pool efforts in developing screening technologies. The authors suggest that developments in fintech, such as the rise of alternative data companies, could eventually improve the efficiency of screening in these markets.