Essays on the emergence of captive finance companies and risk segmentation of the consumer loan market: Theory and evidence

Byung-Uk Chong, Purdue University

Abstract

Essay 1 provides an analytical model for risk segmentation in the perfectly competitive consumer loan market by incorporating the fact that a parental durable good seller with market power to some degree in its product market can earn rents. In this context, there is a gain to granting credit for the purchase of the product and thus the establishment of captive finance company for expanding the sales by offering loans to consumers who need financing for purchase of durable good. The model presents that each captive finance company will set a more lenient credit standard than that of a bank, leading to the prediction that the likelihood of repayment of a captive automobile loan is lower than that of a bank automobile loan, other things being equal. The theoretical predictions in Essay 1 are tested using a unique dataset, TrenData™, drawn from a major credit bureau in the U.S, Trans Union. The analysis of credit bureau data shows that a captive automobile loan is less likely to be repaid than a bank automobile loan, which supports the theoretical prediction. Given the economic feature of a captive finance company examined in Essay 1, Essay 2 examines risk segmentation of consumer loan market by banks and captive finance companies under asymmetric information on a borrower's ability of loan repayment and the borrower's self-selection of the types of loan contract and lending institution. We construct a lending model with adverse selection in consumer loan market on loan rate-approval rate framework. Captive pooling loan contract needs to be subsidized by profits from selling side to sustain. A low-risk borrower is indifferent between separating bank low-risk loan contract and captive pooling loan contract while a high-risk borrower strictly prefers captive pooling loan contract to bank separating high-risk loan contract. The model successfully explains the prevailing wisdom in lending practices that captive finance companies serve on average more high-risk borrowers offering more lenient loan approvals and higher loan rate than banks.

Degree

Ph.D.

Advisors

Barron, Purdue University.

Subject Area

Business costs|Finance|Economic theory

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