Abstract

AbstractThis article tests for bias in consumer lending using administrative data from a high-cost lender in the U.K. We motivate our analysis using a new principal-agent model of bias where loan examiners are incentivized to maximize a short-term outcome, not long-term profits, leading to bias against illiquid applicants at the margin of loan decisions. We identify the profitability of marginal applicants using the quasi-random assignment of loan examiners, finding significant bias against immigrant and older applicants when using the firm’s preferred measure of long-run profits but not when using the short-run measure used to evaluate examiner performance. In this case, market incentives based on characteristics that vary across groups lead to inefficient group-based bias.

Highlights

  • There are large disparities in the availability and cost of credit across different demographic groups within many developed countries

  • Marginal female and male applicants yield statistically identical profits, suggesting no bias against female applicants. We show that these results cannot be explained by other ethnic or age-related differences in baseline characteristics, differences in the level of systematic risk across groups, or the way that the instrumental variable (IV) estimator averages the level of bias across different examiners

  • Immigrant and older applicants are more likely to default in the short run compared to native-born and younger applicants with the same level of expected long-run profits, while no such differences exist for female and male applicants

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Summary

Introduction

There are large disparities in the availability and cost of credit across different demographic groups within many developed countries. In the context of consumer lending, the outcome test is based on the idea that long-run profits to the lender should be identical for marginal applicants from all groups if loan examiners are unbiased and the disparities across groups are solely due to omitted variables or statistical discrimination. Immigrant and older applicants are more likely to default in the short run compared to native-born and younger applicants with the same level of expected long-run profits, while no such differences exist for female and male applicants Taken together, these three results suggest that examiners are equalizing the private returns of lending across groups at the margin, just as predicted by our incentive-based model of bias. The Online Appendix provides additional results, details on two alternative models of bias, and information on the outcomes used in our analysis

An Empirical Test of Bias in Consumer Lending
Models Based on Prejudice and Inaccurate Stereotypes
A New Model Based on the Misalignment of Examiner and Lender Incentives
Testable Implications of the Model
Empirical Test of Bias in Consumer Lending
Institutional Setting
Data Sources and Descriptive Statistics
Construction of the Instrumental Variable
Instrument Validity
Results
Robustness
Comparison to OLS Estimates
Testing the Misaligned Incentives Mechanism
Outcome Test using Short-Run Default
Examiner Decision Rule
Misalignment of Short- and Long-Run Outcomes
Conclusion
Weights IV Weights x 100 x 100
10 Percent 20 Percent 30 Percent 40 Percent
20 Percent 30 Percent
Taste-Based Bias
Inaccurate Group Stereotypes

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