The value of a good credit reputation: Evidence from credit card renegotiations☆
Introduction
Credit reputation, defined as public information on borrower repayment behavior, affects the allocation of consumer credit. Indeed, lenders are more willing to supply credit to borrowers who have a reputation of timely repayment. As a result, borrowers have an incentive to repay their debt to have a clean credit record.1 Previous studies (Brown, Zehnder, 2007, De Janvry, McIntosh, Sadoulet, 2010) and an abundance of anecdotal evidence (e.g., “Effect of Foreclosure on Credit Score” on CreditCardForum2) support this claim.
But there is no direct evidence on how much consumer credit borrowers care about their credit reputations. In particular, asking borrowers how much they would pay in exchange for a clean credit record is typically infeasible or unreliable. An alternative approach, which I pursue in this paper, is to infer borrowers’ willingness to pay for a clean credit record from debt repayment. However, uncollateralized borrowers may repay for a number of other reasons, such as to avoid non-pecuniary costs of default (e.g., moral and social costs). The empirical challenge associated with this approach is to isolate the amount borrowers repay to have a good credit reputation from what they pay for other reasons.
In this paper I exploit a natural experiment to estimate the willingness to pay for a good credit reputation of a group of consumer credit borrowers. To my knowledge, this is the first paper to estimate this measure.3 The natural experiment allows me to address the empirical challenge described above and resembles the following idealized setting. Consider two identical uncollateralized consumer credit borrowers, T and C (for “Treated” and “Control,” respectively) who are in default—i.e., have stopped making their payments—and, as a result, have a bad credit reputation as seen by other lenders. By revealed preference, either both borrowers’ willingness to pay to have a clean credit record is less than their full payment due, or they both face a binding liquidity constraint that prevents them from paying. Suppose the creditor offers both borrowers a renegotiation of their repayment terms that lowers their payments due, thereby helping to relax any liquidity constraint they may face. However, the offers differ in one respect: the lender also offers to restore T’s public credit reputation, while C will still appear as in default to outside lenders, even if she repays. Because all other contract terms are held constant, the difference between the expected repayment of T and C after the renegotiation corresponds to their willingness to pay to have a good credit reputation.
The natural experiment, which closely resembles the above idealized experiment, was implemented by a large department store in Chile (The Store) that issues unsecured credit cards. Clients of The Store use the credit card to buy products or for cash advances and repay in fixed monthly installments. A borrower who misses one monthly installment is in default and receives a negative entry in the credit bureau—i.e., has a bad credit reputation. If the borrower pays the late installments any time before reaching 180 days in default, the negative entry is eliminated and no record of it is available to users of the credit bureau. However, after 180 days in default The Store writes off the debt and the negative entry remains as public information in the credit bureau for at least five more years, even if the borrower agrees to pay.4 The information in the credit bureau is primarily used by lenders to infer a borrower’s creditworthiness, but it is also used informally and many times illegally in other settings (e.g., when evaluating job candidates or for long-term cellular phone contracts). Anecdotal evidence suggests that Chileans are well aware of the costs of having a bad credit reputation.5
The natural experiment occurred as follows. All borrowers whose debts are written off—i.e., who are in default for more than 180 days—receive from The Store an offer via phone or email to renegotiate their debt. This policy allows all borrowers to pay their debt in lower installments after write off. Borrowers may reject this offer, in which case The Store may sue to recover the balance. However, The Store does not typically pursue judicial enforcement given the relatively high legal costs and small balances involved. In this setting, on February 2010, The Store began an unexpected monthly phone campaign with the purpose of offering a renegotiation to borrowers who were in default for more than 30 but less than 180 days. Borrowers who endogenously accepted this offer to renegotiate before write off also lowered their monthly installments and agreed to pay more installments. Importantly, because renegotiations were offered before write off, borrowers who accepted them also obtained a clean record at the credit bureau for as long as they paid their new installments on time.
My empirical strategy consists of measuring the repayment of borrowers who renegotiate before write off in excess of what their own counterfactual repayment would have been had they instead not renegotiated with The Store. This comparison closely resembles the idealized setting described above: just like borrower T in the idealized setting, delinquent borrowers who renegotiate before write off face a lower monthly payment and are able to obtain a clean slate with the credit bureau. On the other hand, just like borrower C in the idealized setting, borrowers who do not renegotiate before write off and remain in default can also lower their monthly payment after write off but cannot obtain a clean credit record.6
The remaining challenge is to estimate the repayment of borrowers who renegotiate before write off in excess of their own counterfactual repayment had they not renegotiated, which is not observable. Because renegotiating before write off is an endogenous outcome, the counterfactual repayment is not necessarily the average repayment of borrowers who do not renegotiate. Indeed, borrowers who renegotiate before write off may be different from those who do not in ways that are correlated with ex post repayment, a classic selection bias. One possible way to address this bias is to compare the repayment of borrowers before and after write off. But borrowers know that write off occurs after 180 days late. Thus, they endogenously choose to be late by more or less than 180 days, and the selection bias is not resolved. Instead, to overcome this bias I exploit the fact that, as part of The Store’s phone campaign, renegotiations before write off were only offered to borrowers whose outstanding balance was higher than an arbitrary and previously unknown cutoff of 50,000 Chilean pesos (roughly USD100). Not all borrowers above the cutoff renegotiate before write off: indeed, borrowers may instead remain in default or repay their late installments. As a result, the fraction of borrowers who renegotiate before write off is discontinuously higher for balances slightly above the cutoff.
I implement a fuzzy regression discontinuity design (fuzzy RD) that exploits the 50,000 pesos cutoff as a source of exogenous variation in the probability that a borrower renegotiates before write off to estimate the willingness to pay for a clean credit record. The outcome variable, which estimates a borrower’s expected repayment, is the sum of the discounted repayments to The Store after the renegotiation campaign starts, including payments made after write off.7 The fuzzy RD estimator corresponds to the difference in the average discounted repayment of all borrowers whose balance is above and below the cutoff, divided by the difference in the fraction of borrowers who renegotiate before write off above and below the cutoff (a Wald estimator).
I find that renegotiation before write off increases borrowers’ repayment to The Store by an amount equivalent to 11% of their monthly income. I interpret this amount as borrowers’ willingness to pay for a clean credit record. Further, by estimating the fuzzy RD specification with default as the outcome variable, I find that renegotiation before write off only delays default for four months. After this time, borrowers who renegotiate before write off are no more likely than their counterfactual to be in good standing at The Store, and thus to have a good public repayment record. Hence, the above estimate of 11% of monthly income measures borrowers’ willingness to pay for a temporary—i.e., four months—good credit reputation.
My results are inconsistent with an interpretation in which borrowers do not value their credit reputation and instead always repay their debt once a minimum level of subsistence consumption is met, a “liquidity constraint” story. Indeed, any liquidity constraint is relaxed by the renegotiation before write off as well as by the renegotiation after write off (i.e., for borrower T and for borrower C in the idealized setting). Under that interpretation, contrary to the evidence, borrowers who renegotiate before write off would not necessarily repay more than their counterfactual.8 The results are also inconsistent with alternative behavioral interpretations such as that the phone call acts as a nudge (Cadena, Schoar, 2011, Karlan, McConnell, Mullainathan, Zinman, 2010, Kast, Meier, Pomeranz, 2012) or that the lower renegotiated installments are viewed as a norm (Navarro-Martinez, Salisbury, Lemon, Stewart, Matthews, Harris, 2011, Stewart, 2009), because both renegotiations before and after write off affect borrowers similarly along these dimensions.
I provide further support for my interpretation by analyzing the first-order benefit borrowers may obtain from a temporary good credit reputation: it gives an option to access formal credit markets. If this option is valuable, some borrowers will exercise it and take on more debt from other lenders. To examine this hypothesis I collect each individual’s aggregate bank debt, and match these data to The Store’s data set with the use of the unique national tax identifier. I find that borrowers above the cutoff increase their bank debt—specifically mortgage debt—relatively more than borrowers below the cutoff. This evidence suggests that, as in the United States, the supply of mortgage debt depends on the borrower’s credit reputation (e.g., Keys, Mukherjee, Seru, Vig, 2010, Mian, Sufi, 2009).
The critical feature of the empirical setting that allows me to measure borrowers’ willingness to pay for a good credit reputation is that, to users of the credit bureau, borrowers who renegotiate before write off become indistinguishable from those who have repaid their original installments.9 But, in this context, credit reputation becomes a noisier signal of the borrower’s true creditworthiness. Thus, other creditors may end up lending to a less creditworthy pool of borrowers. Consistent with this hypothesis, I find that ex post bank default rates increase more for borrowers above the cutoff relative to borrowers below it. A renegotiation before write off can then be understood as a form of collusion between The Store and borrower that imposes a negative informational externality on a third party, such as banks.
This result suggests that some renegotiations, in this case those that occur before write off, may be ex post welfare decreasing, a point that has received little attention in the literature. Instead, the literature typically assumes that renegotiation is not only privately beneficial to the contracting agents but also ex post efficient. An exception is Aghion and Bolton (1987), who study how privately optimal bilateral contracts may reduce welfare. Likewise, Musto (2004) documents a similar pattern for borrowers whose credit reputation improves as they emerge from bankruptcy: they borrow more and then default more. The results also imply that lenders may benefit from offering modifications that allow delinquent borrowers to improve their credit reputations upon repayment. This relates to previous literature that has found that, in general, renegotiation of delinquent mortgage debt has not been a successful policy tool following the 2008 financial crisis, as measured by low take-up and unchanged recovery rates.10 However, the overall welfare effect of offering these modifications is unclear, as these bilateral modifications may impose an informational externality on other lenders. Further, mortgage credit markets are significantly different from The Store’s type of credit (e.g., mortgages are collateralized and open to securitization). Finally, the general equilibirium effects of modifying a cost of default, in this case, of having a bad credit record, are out of the scope of my analysis.
The rest of the paper is organized as follows. Section 2 presents the empirical setting. Section 3 measures the willingness to pay for a temporary good credit reputation. Section 4 shows the effects of the temporary good credit reputation on the access to credit with other lenders, along with the informational externality. Section 5 concludes.
Section snippets
The department store industry in Chile
The Store is one of three large department store chains operating in Chile. These stores issue installment credit cards that represent approximately 41% of the 11.6 million credit cards issued in Chile by number—the balance being bank issued revolving—debt credit cards.11 Clients use the cards to buy products on credit (typically only for products sold by the issuer) and to take short-term cash advances. Repayment is structured
Empirical implementation
The outcome of interest, ex post debt repayment, is not directly observable in the data. I construct this variable using the available data on monthly balances and transactions in the following manner. Each monthly net payment, paymentst, is calculated as the sum of outstanding balance reductions (payments in good standing including capital and interest), plus recoveries or payments made after write off, plus upfront payments in renegotiations, minus the value of new credit (products and cash
Access to credit with other lenders
A test of whether a good credit reputation has value is if borrowers make use of it (or, “cash in” on their reputation) by increasing their debt with other lenders. I collect an individual-level data set of bank debt aggregated across all banks in Chile for borrowers in the renegotiation offer sample. I use these data to test whether acquiring a good credit reputation through a renegotiation before write off allows borrowers to increase their bank debt. In principle, the same fuzzy RD design
Conclusion
This paper studies borrower reputation in consumer credit markets. Specifically, the paper makes two main contributions. First, using a natural experiment, I quantify borrowers’ willingness to pay for a good credit reputation. This is a quantitative assessment of a cost of default that may help sustain repayment in uncollateralized credit markets. I show that borrowers value a temporary good credit reputation because it gives the option to access formal credit markets. Other margins through
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I thank Daniel Wolfenzon, Daniel Paravisini, Wei Jiang, and Andrew Hertzberg for their invaluable comments, patience, encouragement, and support. I also thank Jose Miguel Cruz at the Centro de Finanzas of Universidad de Chile, Fernando Contardo and Ingrid Barahona at SINACOFI, and two officers at the data provider for giving me access to their data sets and for crucial clarifications. Finally, I thank an anonymous referee, Patrick Bolton, Emily Breza, Steve Figlewski, Juanita Gonzalez-Uribe, Mauricio Larrain, Holger Mueller, Mitchell Petersen, Tomasz Piskorski, Jonah Rockoff, Phillip Schnabl, Antoinette Schoar, Assaf Shtauber, Margarita Tsoutsoura, and seminar participants at Banco Central de Chile, Berkeley Haas School of Business, Boston College Carroll School of Management, Chicago Booth School of Business, Columbia Graduate School of Business, Duke Fuqua School of Business, MIT Sloan School of Management, New York Federal Reserve Bank, NYU Stern School of Business, London School of Economics, UCLA Anderson School of Management, UNC Kenan-Flagler Business School, Universidad de Chile, and Rochester Simon School of Business for comments and suggestions. Supported by the Chazen Institute of International Business at Columbia Business School. All errors and omissions are mine only.