November 13, 2015
Are credit histories too revealing?
The merits of making lenders "forget" past transgressions
Adverse information on a credit report, like a past bankruptcy or home foreclosure, can make it very difficult to secure a new line of credit. In most countries, credit bureaus must eventually drop such events from their reports after a period of years.
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The U.S. economy has largely bounced back from a recession that officially ended more than six years ago, but some consumers who experienced financial calamity during the downturn are still reeling. Charge-offs, foreclosures, and personal bankruptcies appear on credit reports for years, and black marks on a credit check can make it very hard to get a new credit card, car loan, or find a new job.
The Fair Credit Reporting Act mandates that U.S. credit bureaus must eventually erase derogatory information from their credit reports. Bankruptcies must be erased after ten years, and other events like debt collections can only be reported for seven years. Consumer advocates have pushed to shorten these reporting periods, and while recent attempts in Congress at reform have not succeeded, this is still a relevant issue for the millions of Americans who are still hounded by past credit troubles.
Economists generally think that markets are at their most efficient when market participants have access to as much information as possible. So will a move to erase negative information from credit histories help increase borrowers' access to mortgages and small business loans? Or will it just prompt worried lenders to be more selective about their customers, ultimately making it harder for everyone to access credit? An article in this month's issue of theAmerican Economic Journal: Microeconomics considers this question with the help of a game theoretical model.
In Bankruptcy: Is It Enough to Forgive or Must We Also Forget? (PDF), authors Ronel Eluland Piero Gottardi construct a model of the consumer credit market where a group of entrepreneurs with varying levels of creditworthiness all seek repeated loans in a market. Lenders can see the credit history of entrepreneurs who have gone bankrupt in the past and can withhold credit from them if they wish, but the information will be "forgotten" after a period of time and no longer appears in the credit history. By varying the time period for forgetting, the authors can use the model to make qualitative predictions about how changes to credit reporting laws can affect credit markets.
Of the 113 countries with credit bureaus as of January 2007, over 90 percent of them had provisions for restricting the reporting of adverse information after a certain period of time . . . It is interesting to note that countries in which defaults are always reported tend to have lower provision of credit than those countries in which defaults are not reported (“erased”) after a certain period of time.
Elul and Gottardi (2015)
The author’s model centers on the problem of asymmetric information, which is a major consideration in the credit market, just as it is in the market for health insurance. One of the principles of good banking is "knowing your customer," but that can be difficult in a nationwide, anonymized market where credit bureaus are forbidden from including all relevant information in their reports.
Lenders are worried about two problems: the first is that their credit card offers will disproportionately attract desperate and risky customers who are likely to default (what economists would call adverse selection). Once a loan is made, there is also no way to distinguish entrepreneurs who got unlucky from those who simply didn't try very hard, and banks have to absorb the losses in bankruptcy in either case (a prime example of moral hazard).
Both of these issues arise from a lack of information: if lenders could "know their customers" better, these problems wouldn't be as severe. Will a requirement for lenders to forget some information about their customers exacerbate these problems?
The authors' model shows that with enforced "forgetting" of bankruptcies, the moral hazard problem does indeed get worse because the punishment for failing is less severe. In a world where bankruptcies are forgotten quickly, people who secure loans do not worry too much about working hard to avoid a bankruptcy. Evidence from a sample of Experian credit reports shows that consumers are able to take out many more new credit cards when bankruptcies are removed from their credit report (see figure below).
Removing an old bankruptcy flag from a credit report
New credit cards obtained by a sample of U.S. consumers who had old bankruptcy flags removed from their credit reports in 1997 and 1998. Successful credit card applications jumped in the months after removal.
Source: adapted from Figure 4 of Musto (2004), data from Experian records
However, the model also demonstrates a countervailing benefit of enforced forgetting: bankrupt entrepreneurs still have something to strive for even if they go bankrupt once. In an equilibrium where bankruptcy cuts off access to any form of credit permanently, a failed entrepreneur has little reason to try to make other projects succeed, and won't ever be productive again because she cannot access new credit. But if the failed entrepreneur can look forward to a fresh start, she still has good incentives to succeed moving forward. In some cases, that benefit could outweigh the cost of reducing the pain of default.
The authors run the model with a range of assumptions to test the limits of this potential benefit. They find that, as long as the moral hazard problem is not too large, and there are not too many "risky" borrowers in the mix, enforced forgetting of past bankruptcies increases total social surplus (in this context, the sum of lender profits and entrepreneurs' profits). Carefully sucking some information out of this market actually allows it to create more total profit.
Despite this benefit, a "forgetting" policy only arises if enforced by an outside authority – banks never want to voluntarily ignore old information on bankruptcies. If forgetting old bankruptcies really helps increase social welfare, why doesn't it arise naturally in the free market?
The authors' answer is that lenders in the model never want to lend to someone who has proven himself to be a high-risk customer by going bankrupt. Only when they lose access to past information do they open up to customers who might have previously gone bankrupt (anyone might be harboring a hidden bankruptcy in their past, so banks cannot avoid these customers without shutting down completely).
The model highlights the potential benefits of forgetting past bankruptcies, but the optimal statute of limitations for reporting (currently at ten years for bankruptcies in the U.S.) is still an open question. Research from Sweden suggests that forgetting past defaults after just a couple of years could be optimal, but more empirical research is needed to come to a conclusion on whether the current ten-year reporting window in the United States is too short or too long. Until then, consumers with spotty credit will still be able to look forward to an eventual fresh start. ♦
"Bankruptcy: Is It Enough to Forgive or Must We Also Forget?" appears in the November 2015 issue of the American Economic Journal: Microeconomics.