2. A Historical Study on the Evolution of Risk Assessment and Credit
2.2. The Role of Credit Information Sharing as a Solution to the Information
The origins and evolution of modern and institutionalised information providers, such as the main credit rating agencies, credit bureaux or credit reference agencies, can be traced to the historical functioning of financial markets and explained by the existence of information asymmetries embedded in the investor-borrower relationship. Lenders screen and evaluate the creditworthiness of potential borrowers in order to price loans accordingly. Theoretical studies suggest that, in a perfectly efficient market, the risk profile of a borrower always reflects the interest rate on a loan; in other words, the higher the risk profile of an individual borrower, the higher the interest rate of the loan. Therefore, in theory, financially sound borrowers should always be able to obtain low interest rates on loans, whereas high-risk borrowers should always either be charged a very high interest rate or be rejected from obtaining funding altogether. Information plays therefore a fundamental role to assess individual risk profiles.
According to Jappelli and Pagano (2000), this information can originate from three sources: First, a lender (or a bank, as in Jappelli and Pagano, 2000) might already be in possession of information relevant to the assessment of individual risk (risk profile), which was acquired through an investment in a long-term relationship with a specific customer over time. Small banks, for instance, employ longstanding relationships (relationship banking) to obtain soft information and evaluate the profile of individual borrowers through
‘multiple interactions with the same customer over time and/or across products.’8 Second, a lender can obtain the information directly from readily available public records, by interviewing the potential borrower and/or visiting her or his business. The acquired information can then be processed (qualitatively and/or quantitatively, through statistical risk management methodologies) in order to take decisions about loan granting and to price it according to the individual risk characteristics. Lastly, the third way to get information on a potential credit candidate identified by Jappelli and Pagano (2000) is to
8 Boot (2000), p. 10.
acquire it from other lenders who have previously performed business with the specific credit seeker and therefore possess valuable information. In return, the provider of the credit-relevant information requires a reciprocal obligation from the receiver to share her or his own information about potential borrowers when needed. Thus, an information sharing arrangement is essential between lenders.
Nevertheless, studies suggest that the real economy is characterized by imperfect information; that is, borrowers have a superior knowledge regarding their own creditworthiness (or their ability and willingness to pay their financial obligations within a previously agreed specific schedule) than lenders9. Furthermore, asymmetric information may inhibit the efficient allocation of resources through lending (Jaffee and Rusell (1976), Stiglitz and Weiss (1981)), and increase credit rationing. Akerlof (1970) describes a market in which a seller possesses more information than a buyer on a particular product, and shows that the existence of a given level of information asymmetry might work to the disadvantage of good quality sellers, thus giving rise to an adverse selection problem: in a capital market characterized by creditworthiness uncertainty, investors would not be able to differentiate between bad and good investments, resulting in an interest rate that does not reflect the underlying risk of borrowers. Thus, the benefits of the reduction of the information asymmetries in financial markets can be derived: the common knowledge of positive past credit performances should turn to the advantage of financially sound borrowers in the form of lower interest rates and more access to credit at lower costs. On the other hand, the reduction of information asymmetries could also take the role of an incentive for risky borrowers to try to improve their credit performances in order to obtain more advantageous credit terms. Overall, the enhancement of public information regarding the creditworthiness of borrowers should lead to a more efficient allocation of capital in a given economy, in accordance to both public and private interests. Analogously, an efficient bond market requires the information asymmetries to be reduced.
Extensive research has been performed on the role of information sharing in the reduction of information asymmetries between borrowers and lenders, and it is important for a number of reasons: first, information sharing can prevent the previously discussed adverse selection problems. In the absence of information relevant to the assessment of the specific risk profiles of potential credit candidates, there is a high probability that lenders end up granting credit to risky individuals, the most likely to accept the elevated price of loans stemming from the prevailing uncertainty with regard to the underlying
9 Stiglitz and Weiss (1981).
creditworthiness of market participants. Using a theoretical framework, Pagano and Jappelli (1993) show that information sharing, the exchange of information among lenders through information brokers (private credit bureaus), can reduce information asymmetry between lenders and borrowers leading to an increase in aggregate lending when adverse selection is so extreme that financially sound borrowers drop out of the market. Jappelli and Pagano (2002) employ a new purpose-built dataset on modern private and public forms of credit information sharing institutions (private credit bureaus and public credit registries) and show that bank lending is higher in countries where information sharing is an established practice among lenders. Similarly, other empirical works such as Brown et al. (2009), Love and Mylenko (2003), Galindo and Miller (2001) and Powell et al. (2004) present evidence suggesting that the level of aggregate lending is positively associated with the existence of credit information sharing institutions.
Second, information sharing counters moral hazard. As discussed by Jappelli and Pagano (2002), ‘information sharing can reinforce borrowers’ incentives to perform, either via a reduction of lenders’ (or banks’) informational rents or through a disciplinary effect.’10 With regard to the first mechanism to enhance the borrowers’ incentives to perform, via a reduction of lenders’ rents, Padilla and Pagano (1997) show (using a theoretical framework) that when lenders (or in this specific case, banks) commit to share with other lenders their private information about the creditworthiness of their customers, banks can encourage borrowers to perform better. When lenders have an informational monopoly about their borrowers and are therefore able to charge excessive or ‘predatory’ rates in the future due to an increase in their market power, borrowers have less incentives to perform, leading in turn to higher probabilities of default and increased overall interest rates. In other words, in the absence of credit information sharing, if borrowers perceive that the bank is able to appropriate a high proportion of their future investment’s returns through excessive interest rates stemming from an informational advantage (and the resulting monopolistic position that gives rise to a hold-up problem), they will very likely exert lower efforts to perform. Therefore, the sharing of information between lenders about the creditworthiness of their customers limits the ability of the former to engage in opportunistic behaviour and extract informational rents through excessive interest rates on loans. This increases borrowers’ incentives to perform better and results in a decrease of the likelihood of default of individual customers and an increase in overall aggregate lending.
10 P. 2019.
In relation to the second mechanism to reinforce borrowers’ incentives to perform, the disciplinary effect, Padilla and Pagano (2000) show that credit information sharing not only reduces (ex ante) adverse selection problems but also diminishes (ex post) moral hazard via a disciplinary effect. If lenders share default information about their borrowers, the latter must consider that default on one lender will negatively affect their reputation with all other future potential lenders, making credit more expensive through higher loan interest rates or even cutting her or him off from credit altogether. Therefore, the disciplinary effect arising from the existence of credit information sharing organisations should, theoretically, provide a stronger incentive for borrowers to exert a higher level of effort to perform, decreasing the probability of default of individual customers and ultimately increasing lenders’ returns by reducing losses from bad debt. Conversely, without credit information sharing, borrowers might be tempted to repay their financial obligations only when they plan to maintain a longstanding relationship with a lender (Brown and Zehnder (2007)).
Nevertheless, the effects of information sharing as a disciplinary device on the behaviour and performance of borrowers are also dependent upon the type of information shared11: sharing customers’ information about past defaults yields different results than sharing information about their quality. More specifically, the disciplinary effect materialises only when the exchange of information is exclusively focused on defaults. As shown by Padilla and Pagano (2000), divulging information about the borrowers’ quality (instead of information about borrowers’ past defaults) can reduce the disciplinary effect of information sharing, leaving the level of default and interest rates unchanged: in the banking context, if ex ante competition discards potential informational rents, then the level of loan interest rates cannot be diminished further. Therefore, ‘when information about their quality is shared, borrowers have no reason to change their effort level, and equilibrium default and interest rates stay unchanged.’12 Furthermore, if lenders share information about both past defaults and borrower characteristics, the disciplinary effect of information sharing is diluted: a high-grade borrower will not have a stronger incentive to perform or avoid default if she or he is aware that lenders will disclose her or his high intrinsic quality in addition to a previous event of default. This might be explained by the fact that the borrower can be certain that other lenders will not interpret default as a sign of low quality (Padilla and Pagano (2000)). Consistent with these findings, Doblas-Madrid and
11 This is the main reason why the present study, employing a historical approach, focuses not only on the evolution of credit information sharing but also on the type of information that lenders shared and used to assess potential borrowers’
creditworthiness.
12 Jappelli and Pagano (2002), p. 2020.
Minetti (2013) show that information exchange has a positive effect on the payment behaviour of firms, especially in the case of young and small firms that have a reputation to be less informationally transparent.
In practice, modern forms of sharing information organisations such as the main credit rating agencies, for instance, claim that they help reduce the asymmetries among lenders and borrowers through an established and defined ranking system (credit ratings) that reflects the ability and willingness of an issuer of fixed-income securities to make full and timely payment of amounts due on a given security over its life. The ranking system used by credit rating agencies to assign ratings is based on calculations that should reflect the underlying probability that the financial obligations (principal and interest) will be met according to a defined schedule, on the one hand, and the rate of recovery should the firm go into default, on the other.