A Theory Of Credit Scoring And Competitive Pricing Of Default Risk

The authors propose a theory of credit scoring based upon an adverse selection approach to reputation. Specifically the authors analyze an unsecured consumer credit market where: Borrowers have the legal option to default; defaulters are not exogenously excluded from future borrowing; there is free entry of lenders; and lenders cannot collude to punish defaulters. In the framework, limited credit or credit at higher interest rates following default arises from the lender's optimal response to limited information about the agent's type and earnings realizations.