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. The authors explore two different mechanisms through which repayment behavior in the credit market can be positively correlated with low-risk status in the insurance market. Their theory is motivated in part by some facts regarding the role of credit scores in consumer credit and auto insurance markets.View the Full Working Paper
A Finite-Life Private-Information Theory of Unsecured Consumer Debt
WP 07-14 – The authors 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.