Competition and Selection in Credit Markets

We present both theory and evidence that increased competition may decrease rather than increase consumer welfare in subprime credit markets. We present a model of lending markets with imperfect competition, adverse selection and costly lender screening. In more competitive markets, lenders have lower market shares, and thus lower incentives to monitor borrowers. Thus, when markets are competitive, all lenders face a riskier pool of borrowers, which can lead interest rates to be higher, and consumer welfare to be lower. We provide evidence for the model’s predictions in the auto loan market using administrative credit panel data.