Understanding new institutions in consumer credit Institutions like online marketplaces and high-cost credit markets are an important source of credit to consumers, yet taking out high-cost credit can have long term financial consequences. We spoke to Professor Daniel Paravisini about his research into how the growth of these institutions is affecting the consumer credit market. An
increasing proportion of consumer credit is being provided by sources from outside the regular banking sector, for example online credit markets in the US, and high-cost lenders. As the Principal Investigator of a new ERC-funded project, Professor Daniel Paravisini is investigating how this trend is affecting the consumer credit market. “With online marketplaces people can borrow quite large amounts of money, up to £30,000, while high-cost lenders offer loans to people on the basis of very little information,” he says. The focus in the project is on the functions of these new sources of credit, the benefits they bring, and also the consequences to consumers of using high-cost credit. “In the UK once you’ve used high-cost credit, and this information is disclosed to lenders via your credit report, then you are essentially flagged by lenders as a potentially high-risk borrower, even if you repaid the loan,” outlines Professor Paravisini.
High-cost credit
Photo by Avery Evans
The people who use high-cost credit are commonly thought to be more likely to be in financial distress, yet it is not clear whether this is a consequence of taking a high-interest loan or whether their finances were already over-stretched beforehand. There can be a fine line between being accepted and rejected for a loan, a point that Professor Paravisini has been exploring in his research. “We know that below that a certain cut-off on a credit score, you are more likely to be rejected when you apply for a loan,” he explains. By tracking two people with marginally different credit scores over time – one who took a loan and one who didn’t – Professor Paravisini hopes to shed new light on the importance of reputation to financial health. “Once you take out the loan,
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we look at what happens subsequently. When you renew the loan, what’s the likelihood of you repaying those loans?” he continues. This research holds important implications for regulations around credit reports, an area where there are clear differences between some countries. While in the US for example the FICO credit score does not include the use of high-cost credit, this information is included
consumer credit. In terms of high-cost credit, the focus is on characterising the reputational cost to the borrower, while with online marketplaces, Professor Paravisini is looking at how high and low-risk borrowers can be distinguished. “We’re looking at the mechanisms these online marketplaces have to distinguish between high- and low-risk borrowers,” he continues. Online
In the UK once you’ve used high-cost credit, and this information is disclosed to lenders via your credit report, then you are essentially flagged by lenders as a potentially high-risk borrower, even if you repaid the loan. in the UK. “In the UK if you take out a highcost loan, there’s going to be a flag in your credit history,” explains Professor Paravisini. The US approach to an extent reflects a desire to remove the stigma attached to using high-cost credit, yet limiting the amount of information available on consumers in their credit rating could have wider effects. “The ability of regular banks to gauge your risk would potentially be diminished. This could mean that the costs of mortgages would go up – it could also mean that some people that would have had a mortgage approved in the past now don’t,” says Professor Paravisini. “The impact really depends on the extent of the reputational cost.” The wider aim in this research is to build a deeper picture of the benefits and costs associated with these new institutions in
marketplaces typically serve a very different segment of the population to high-cost credit markets, yet they both serve the same purpose and are increasingly prominent features of the financial landscape, now Professor Paravisini aims to gain further insights into how they function. “We’re looking at the consequences, costs and benefits of these new institutions in consumer credit,” he says.
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Institutions in Consumer Credit Funded under H2020-EU.1.1. / Grant agreement ID: 772200. Overall budget € 1 017 851 Project Coordinator, Professor Daniel Paravisini London School of Economics and Political Science Houghton Street London WC2A 2AE UK T: +44 (0)20 7107 5371 E: d.paravisini@lse.ac.uk W: https://www.lse.ac.uk/ Finance/People/Faculty/ Paravisini Daniel Paravisini is Professor of Finance at the London School of Economics and Social Sciences in the UK. He gained his PhD in Economics from MIT in the US, and has held academic positions in South America, the US and Europe. He is the co-editor of the Journal of Law, Economics and Organization.
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