Observing Unobservables

“Observing Unobservables: Identifying Information Asymmetries
with a Consumer Credit Field Experiment”
Princeton University, Yale University, Economic Growth Center
Federal Reserve Bank of New York

Information asymmetries are important in theory but difficult to
identify in practice. We estimate the empirical importance of
adverse selection and moral hazard in a consumer credit market
using a new field experiment methodology. We randomized 58,000
direct mail offers issued by a major South African lender along
three dimensions: 1) the initial “offer interest rate” appearing
on direct mail solicitations; 2) a “contract interest rate”
equal to or less than the offer interest rate and revealed to
the over 4,000 borrowers who agreed to the initial offer rate;
and 3) a dynamic repayment incentive that extends preferential
pricing on future loans to borrowers who remain in good
standing. These three randomizations, combined with complete
knowledge of the Lender’s information set, permit identification
of specific types of private information problems. Specifically,
our setup distinguishes adverse selection from moral hazard
effects on repayment, and thereby generates unique evidence on
the existence and magnitudes of specific credit market failures.
We find evidence of both adverse selection (among women) and
moral hazard (predominantly among men), and the findings suggest
that about 20% of default is due to asymmetric information
problems. This helps explain the prevalence of credit
constraints even in a market that specializes in financing
high-risk borrowers at very high rates.

JEL Classification: C9, D8, G2, G3, O1