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A Quantitative Theory of the Credit Score

Working Paper 770 | Published August 4, 2020

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Authors

Satyajit Chatterjee Federal Reserve Bank of Philadelphia

Kyle Dempsey Ohio State University

photo of José-Víctor Ríos-Rull

José-Víctor Ríos-Rull University of Pennsylvania, CAERP, CEPR, NBER, and UCL

A Quantitative Theory of the Credit Score

Abstract

What is the role of credit scores in credit markets? We argue that it is a stand in for a market assessment of a person's unobservable type (which here we take to be patience). We pose a model of persistent hidden types where observable actions shape the public assessment of a person's type via Bayesian updating. We show how dynamic reputation can incentivize repayment without monetary costs of default beyond the administrative cost of filing for bankruptcy. Importantly we show how an economy with credit scores implements the same equilibrium allocation. We estimate the model using both credit market data and the evolution of individual's credit scores. We find a 3% difference in patience in almost equally sized groups in the population with significant turnover and a shift towards becoming more patient with age. If tracking of individual credit actions is outlawed, the benefits of bankruptcy forgiveness are outweighed by the higher interest rates associated with lower incentives to repay.