Borrower Selection into Credit Markets: Evidence from Peer-to-Peer Lending

Abstract

We exploit a quasi-natural experiment in the peer-to-peer lending market to show that the mechanism determining interest rates, irrespective of their levels, influences households' decisions to participate in credit markets. A large online platform unexpectedly switched from auction pricing of loans to centralized price assignment by credit grade. After the change all borrowers in a given credit grade were assigned the same interest rate, potentially exacerbating asymmetric information between borrowers and lenders. Surprisingly, we find that the creditworthiness of borrowers listing on the platform improves. This effect is mainly driven by lower quality borrowers leaving the platform, and is most pronounced for households looking to consolidate existing debt. As a result, less credit is allocated to lower credit quality borrowers. Our findings suggest that the manner in which interest rates are set is an important determinant of households' financing decisions and of selection into credit markets.