Abstract
We present a theory of unsecured consumer debt that does not rely on utility costs of default or on enforcement mechanisms that arise in repeated-interaction settings. The theory is based on private information about a person's type and on a person's incentive to signal his type to entities other than creditors. Specifically, debtors signal their low-risk status to insurers by avoiding default in credit markets. The signal is credible because in equilibrium people who repay are more likely to be the low-risk type and so receive better insurance terms. We explore two different mechanisms through which repayment behavior in the credit market can be positively correlated with low-risk status in the insurance market. Our theory is motivated in part by some facts regarding the role of credit scores in consumer credit and auto insurance markets.
| Original language | English (US) |
|---|---|
| Pages (from-to) | 149-177 |
| Number of pages | 29 |
| Journal | Journal of Economic Theory |
| Volume | 142 |
| Issue number | 1 |
| DOIs | |
| State | Published - Sep 2008 |
Bibliographical note
Funding Information:We would like to thank an anonymous referee, participants at the Journal of Economic Theory Conference in Honor of Neil Wallace, and seminar participants at Georgetown University, Yu-Chin Hsu and Timur Hulagu for their comments and suggestions. Ríos-Rull thanks the National Science Foundation (Grant SES–0079504). The views expressed in this paper are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or of the Federal Reserve System.
Keywords
- Adverse selection
- Bankruptcy
- Credit score
- Default
- Insurance
- Unsecured consumer debt