Information Asymmetries in Consumer Lending: Evidence from Payday Lending

This paper tests for incentive and selection effects in a subprime consumer credit market. We estimate the incentive effect of loan size on default using sharp discontinuities in loan eligibility rules. This allows us to estimate the magnitude of selection from the cross-sectional correlation between loan size and default. We find evidence of advantageous incentives and adverse selection. We estimate that for a given borrower, a $100 increase in loan size decreases the probability of default by 3.7 to 4.6 percent. The effect is larger for borrowers likely to have low discount rates. The advantageous incentive effect is more than offset by adverse selection into larger loans. Borrowers who choose $100 larger loans are 7.0 to 8.4 percent more likely to default than observationally equivalent borrowers who choose smaller loans. Taken together, our results are consistent with the view that information frictions lead to credit constraints in equilibrium.