A Quantitative Theory of the Credit Score
Abstract: What is the role of credit scores in credit markets? We argue that it is a stand-in for a market assessment of a person’s unobservable type (which here we take to be patience). We pose a model of persistent hidden types where observable actions shape the public assessment of a person’s type via Bayesian updating. We show how dynamic reputation can incentivize repayment without monetary costs of default beyond the administrative cost of filing for bankruptcy. Importantly, we show how an economy with credit scores implements the same equilibrium allocation. We estimate the model using both credit market data and the evolution of individuals’ credit scores. We find a 3% difference in patience in almost equally sized groups in the population with significant turnover and a shift towards becoming more patient with age. If tracking of individual credit actions is outlawed, the benefits of bankruptcy forgiveness are outweighed by the higher interest rates associated with lower incentives to repay.
File(s): File format is text/html https://www.philadelphiafed.org/-/media/research-and-data/publications/working-papers/2020/wp20-39.pdf
Provider: Federal Reserve Bank of Philadelphia
Part of Series: Working Papers
Publication Date: 2020-09-30