Applications of information sharing and credit scoring in the Jaffee & Russell model

In this section I am developing the Jaffee and Russell model further to show effects the information sharing and the credit scoring have in this frame. First I present these two information tools and then show the effects on the equilibrium.

4.4.1 Information sharing

The amount of the information influences the quality of the risk predictions lender can make. Thus it can be assumed that an access to a loan register benefits the lender. The negative credit register is mandatory for all the lenders in Finland so this does not have effects on supply in Jaffee & Russell model but affects the pool of applicants. It can be stated that the negative payment information is known to all lenders and the borrowers with negative payment remark are ruled out from the market. The voluntary credit register on the other hand does have implications on the model. The lenders that belong in the register have better knowledge about ituation than those lenders who do not belong in the register. At the same time they must share the information about their own customers to those lenders who also belong in the register. In the Jaffee & Russell model it was assumed that all lenders know the fraction of good payers in the total population but the positive register alters this situation if all lenders do not have the access to the register. I will assume that the access must cost something to the lender and it must be taken in to account in the model. To do this, I insert two new variablesA[ ]and in the supply function. TheA[ ] describes benefit that a lender gains for the access to the register. It gets value A=1 if lender does not belong to the register and constant value A>1 if he belong to it. The variable describes the cost of access to register. The supply function of a lender then has the following form:

4.4.2 Credit scoring

I have now shown the principles of credit scoring and how it is used. It seems apparent that the credit scoring can lower the informational asymmetry that lender faces and can produce competitive advantage for a lender if he can get better risk predictions out of the scoring process. Similarly than the information sharing this should be taken in to consideration in Jaffee & Russell -model. The credit scoring can improve the lenders portfolio but at the same time the development of such system might be expensive. We can add two variables in the supply function to illustrate this. The variable is describing the positive effect of getting better fraction of good borrowers and describes the cost of the scoring system. It can be further assumed that is growing in . These scoring variables do not have effects on the

demand function as the variables are only affected by lenders choices. The supply function would then be in the following form:

4.4.3 Effects for the equilibrium

Both the positive loan registry and the credit scoring affects the credit supply similarly. They increase the lenders cost but at the same time they make lender s business more profitable. The lender can identify better the borrower s default cost. When the default costs are known to the lender he can give the loan only to the honestly acting borrowers on the given price. We can thus handle both of these with the same variable. A variableX will demonstrate the amount of information and the variable I which was the funding cost of the lender will be seen as a function of X. Also the fraction of the honestly acting borrowers is now presented as a function of X. The information cost could be handled separately from the funding cost like I presented them in 5.4.1 and 5.4.2 but this would make the model more complex. Lenders profit function is now:

Where: = profit L = loan sum R = interest rate

X = the information level a lender acquires with information tools. And the supply curve will be:

There are now two effects happening in the supply curve if we compare the situation on original Jaffee & Russell -model: the cost effect andthe portfolio effect. If a lender earns more

information level I[X] is set by investments X. This cost effect will push the supply curve upwards in the RL-space as I[X=0] < I[X>0]. This will also lift the equilibrium price. The Figure 9 is showing this effect.

Figure 9: The cost effect of information purchase

The portfolio effect comes from the assumption that a lender can make better loan decisions if he has more information. The lender can identify better fraction of honestly acting borrowers and can offer better contracts to them. When the lender can acquire better performing loan portfolio it will bend the supply curve downwards from that point on where the dishonest people will start to default depending on their default cost. This is presented in the Figure 10. The lender can now identify borrower s risk better and offer the loan contracts only to those borrowers whose default costs are higher than the loan payment.

When the supply curve is bending down it also brings the equilibrium rate down. The total change in the equilibrium price depends on these two effects. It can increase it or decrease it depending on the size of the information cost and the portfolio effect. However, regarding to the literature I have presented earlier it can be assumed that the total effect brings the equilibrium price down and benefit the honestly acting borrower.

I[X=0] I[X>0

Figure 10: The portfolio effect of the information purchase