”Irresponsible Lending” May Increase With Reduced Competition

Restricting competition may not help to curb ”irresponsible lending” – lending which the lender knows to be against the interest of the borrower. Indeed, it may actually increase its prevalence, according to new research by Professor Roman Inderst, published in the October 2008 issue of the Economic Journal.

The study argues that irresponsible lending will only be reined in when policy helps to bridge informational gaps: first, between different lenders, thereby curbing individual lenders” market power; and second, between the lender and the borrower.

”Irresponsible” or ”predatory” lending had become a prime topic with financial regulators even before the current turmoil in the financial markets, though some observers see the ”mis-selling” of subprime mortgages in the United States as the origin of this crisis.

The theoretical analysis in this study breaks new ground in that it explicitly takes account of the fact that borrowers may be less ”sophisticated” than their lenders. This stands in sharp contrast to the main paradigm used in financial economics.

”Irresponsible lending” occurs when the lender makes a loan that, given his own information, is against the interest of the borrower.

A key result of the study is that irresponsible lending can occur even when borrowers are fully rational and make unbiased decisions.

They may, instead, simply lack the full information that is available to lenders, given that they can usually only draw on their own, limited experience when, for example, gauging the likelihood that they will be able to repay a loan.

”Irresponsible Lending” with a Better Informed Lender” by Roman Inderst is published in the October 2008 issue of the Economic Journal.

Roman Inderst

University of Frankfurt | inderst@finance.uni-frankfurt.de