The Democratization of Credit and the Rise in Consumer Bankruptcies

Abstract

Financial innovations are a common explanation for the rise in credit card debt and bankruptcies. To evaluate this story, we develop a simple model that incorporates two key frictions: asymmetric information about borrowers' risk of default and a fixed cost of developing each contract lenders offer. Innovations that ameliorate asymmetric information or reduce this fixed cost have large extensive margin effects via the entry of new lending contracts targeted at riskier borrowers. This results in more defaults and borrowing, and increased dispersion of interest rates. Using the Survey of Consumer Finances and Federal Reserve Board interest rate data, we find evidence supporting these predictions. Specifically, the dispersion of credit card interest rates nearly tripled while the "new" cardholders of the late 1980s and 1990s had riskier observable characteristics than existing cardholders. Our calculations suggest these new cardholders accounted for over 20% of the rise in bank credit card debt and delinquencies between 1989 and 1998.

Recent Developments in Consumer Credit and Default Literature

“…While the basic story may have implications for the intensive margin of borrowing, Livshits et al . () choose to concentrate on the extensive margin, the “democratization of credit,” which arises from lenders' choosing to develop credit products for higher risk categories of borrowers, the credit products that generate relatively little surplus and were not profitable when the cost of designing contracts were high. Another paper where the extensive margin of the expansion of borrowing is present is Drozd and Nosal (), who consider a fall in lenders' costs of reaching a specific type of potential borrower, both in the data and in the context of a search model.…”

“…Both channels are clearly present in the data (the extensive margin of debt expansion is cited, for example, in Bird et al (1999), Black and Morgan (1999), Durkin (2000), Moss and Johnson (1999), and Sullivan et al (2000)), but sorting through them is not trivial. Livshits et al (2015) do a decomposition exercise, which attributes about a quarter to a third of the rise in bankruptcies to the extensive margin (which they call "democratization of credit"), while the remainder is attributed to "existing" borrowers. Interestingly, a further decomposition of the intensive margin yields a result similar to that of Gross and Souleles (2002) -most of the intensive margin portion is due to a greater propensity of existing borrowers to file for bankruptcy, rather than greater debt burdens.…”

“…The mechanism presented in Livshits et al (2015) is quite different and emphasizes the extensive margin of extending credit to new (and riskier) borrowers. Unlike the paper discussed above, which model improvements in information quality and lower cost of obtaining such information, Livshits et al (2015) emphasize technological improvements in lenders' ability to process such information.…”

“…For a detailed description of the consumer credit industry and its evolution, please see Evans and Schmalensee () and Livshits et al . ()…”

“…I will forego the discussion of the personal bankruptcy system and characteristics of a typical bankruptcy filer, referring the reader instead to White (2007) and Sullivan et al (2000). 4 For a detailed description of the consumer credit industry and its evolution, please see Evans and Schmalensee (1999) and Livshits et al (2015). 5 The survey is organized as follows: Before going into specific questions and agendas, the next section lays out the key mechanisms and tradeoffs associated with consumer credit and bankruptcy, and presents the key features of the standard models employed.…”