The Role of Information in Lending: The Cost of Privacy Restrictions

The Role of Information in Lending: The Cost of Privacy Restrictions

Order Code RL31847
CRS Report for Congress
Received through the CRS Web
The Role of Information in Lending:
The Cost of Privacy Restrictions
Updated January 29, 2004
Loretta Nott
Analyst in Economics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

The Role of Information in Lending:
The Cost of Privacy Restrictions
Summary
The Fair Credit Reporting Act (FCRA) is the federal law that regulates the
collection, use and disclosure of consumer credit information. In an effort to provide
a national and uniform standard for sharing credit information, there are a number of
FCRA provisions that preempt state law. One of those specific provisions prohibits
states from enacting laws that impose additional restrictions on the type of
information contained in consumer credit reports. The FCRA preemption provisions
were set to expire on January 1, 2004, but the recently enacted Fair and Accurate
Credit Transactions Act of 2003 (P.L. 108-159) makes these preemptions permanent.
Nevertheless, privacy advocates continue to argue for broader financial privacy laws.
They are concerned about the heightened risks to consumers from the widespread
availability of an individual’s financial information, such as identity theft or other
possible means of misuse.

From the perspective of economics, the availability to lenders of complete and
accurate data on past consumer borrowing behavior is considered essential to an
efficient credit market. The ability of borrowers to access credit at reasonable rates
is critical to facilitate investment and commerce, and thereby sustain economic
growth. It is claimed that consumers in the United States have more ready access to
low-cost credit than consumers anywhere else in the world. This is due in part to
public policies, such as the FCRA, that support the pooling and sharing of consumer
credit data.
There is a growing body of economic research suggesting that privacy laws that
restrict the availability of credit bureau data could impose significant economic costs.
These possible costs include higher interest rates, reduced accessibility to credit, and
a lower volume of lending activity. Furthermore, some may argue that credit data
limitations bestow anti-competitive advantages to lenders, which can also lead to
higher loan rates and an increased incidence of default. The disciplinary effect from
information sharing may also be diminished, resulting in a higher level of consumer
indebtedness and a heightened risk of default. Thus, from an economic perspective,
privacy laws that limit the reporting of credit data could impose significant financial
costs on consumers and the economy as a whole. How these costs are weighed
against the benefits of increased financial privacy is a matter for legislative debate.
This report focuses on the potential economic effects of restricting the type of
consumer credit information that is reported between financial institutions and credit
reporting agencies. For an economic analysis of the privacy debate related to the
sharing of financial information among affiliates of the same corporate group, see
CRS Report RL31758, Financial Privacy: The Economics of Opt-In vs Opt-Out, by
Loretta Nott.
This report will be updated as events warrant.

Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
The Role of Information in Credit Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Economics of Credit Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Mitigates Adverse Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Reduces Anti-Competitive Advantages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Discourages Excessive Consumer Indebtedness . . . . . . . . . . . . . . . . . . . . . . 6
The Economic Costs of Credit Data Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . 7
Lending Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Accessibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Delinquency Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Cost of Credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

The Role of Information in Lending:
The Cost of Privacy Restrictions
“Detailed data obtained from consumers as they seek credit or make product
choices help engender the whole set of sensitive price signals that are so essential
to the functioning of an advanced information based economy such as ours. Yet ...
this very mechanism of information creation runs the risk of breaching personal
privacy ... Too little information that can be used in marketing leads to a decline
in the quality of the goods and services offered. Too much can be perceived as an
inordinate incursion of privacy of person.”
- Federal Reserve Chairman Alan Greenspan in a letter
to the Honorable Edward J. Markey, July 28, 1998.1
Introduction
Money and credit are the lifeblood of the U.S. economy. The ability of
borrowers to access credit at reasonable rates is critical to facilitate investment and
commerce, and thereby sustain economic growth. It is claimed that consumers in the
United States have more ready access to low-cost credit than consumers anywhere
else in the world.2 This is due in part to U.S. public policies that support the pooling
and sharing of consumer credit data.
In particular, these policies have promoted the development of one of the most
comprehensive credit reporting systems worldwide. There exists at least one credit
file for every credit-using individual in the country. Two billion pieces of data are
added to these files each month and over two million credit reports are issued each
day by U.S. consumer reporting agencies.3 The availability of complete and accurate
data on past consumer borrowing behavior is considered critical for the delivery of
an economically efficient allocation of credit.
In this regard, several federal laws pertain to the U.S. credit reporting system,
including the Fair Credit Reporting Act (FCRA). The purpose of the FCRA is to
“require that consumer reporting agencies adopt reasonable procedures for meeting
1 To read this letter in its entirety, see the web site of Representative Edward J. Markey at
[www.house.gov/markey/iss_privacy_ltr980728.htm], visited Jan. 29, 2004.
2 See Fred H. Cate, “Privacy, Consumer Credit and the Regulation of Personal Information,”
in The Impact of Public Policy on Consumer Credit, Thomas A. Durkin and Michael E.
Staten, eds. (Boston: Kluwer Academic Publishers, 2002), p. 234.
3 For more information about the consumer reporting industry, see Robert B. Avery, Paul
S. Calem and Glenn B. Canner, “An Overview of Consumer Data and Credit Reporting,”
Federal Reserve Bulletin, February 2003, pp. 47-73.

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the needs of commerce for consumer credit, personnel, insurance, and other
information in a manner which is fair and equitable to the consumer, with regard to
the confidentiality, accuracy, relevancy, and proper utilization of such information.”4
In an effort to provide a national and uniform standard for sharing credit
information, there are a number of FCRA provisions that preempt state law.5 One
of the specific provisions prohibits states from enacting laws that impose additional
restrictions on the type of information contained in consumer credit reports.6 The
FCRA preemption provisions were set to expire at the end of 2003, which meant that
after January 1, 2004, states would have been able to enact laws that limited the
amount and type of information disclosed in consumer reports. However, the
recently enacted Fair and Accurate Credit Transactions Act of 2003 (P.L. 108-159)
makes the FCRA preemption provisions permanent.
Nevertheless, privacy advocates continue to argue for the enactment of broader
financial privacy laws. They are concerned about the heightened risks to consumers
from the widespread availability of an individual’s financial information, such as
identity theft or other possible means of misuse.7 In addition, there appears to be a
general sense of unease among consumers about the potential harms from not being
able to control one’s own information.8 These same concerns have been voiced
around the world, which is why many countries, including Australia and members of
the European Union, have enacted privacy laws that limit the reporting of credit data,
including information on account balances and credit limits.9
However, supporters of maintaining the current flow of credit information point
to a growing body of evidence to suggest that privacy laws that restrict the
availability of credit bureau data could impose significant economic costs. These
4 15 U.S.C. § 1681(b)
5 15 U.S.C § 1681t. For a detailed overview of these preemptive provisions, see CRS Report
RS21449, Fair Credit Reporting Act: Preemption of State Law, by Angie A. Welborn.
6 15 U.S.C. § 1681c, section 605.
7 For a comprehensive study on identity theft, see Federal Trade Commission, Federal Trade
Commission - Identity Theft Survey Report, prepared by Synovate, September 2003, at
[http://www.ftc.gov/os/2003/09/synovatereport.pdf], visited on Jan. 29, 2004.
8 For a detailed overview of privacy concerns related to the sharing of consumer credit
information, see Cate, “Privacy, Consumer Credit, and the Regulation of Personal
Information,” pp. 229-276. For a list of the major advocacy groups, such as Privacy
International, U.S. PIRG, and the Privacy Rights Clearinghouse, as well as links to their
websites, visit [www.privacyrightsnow.com], visited Jan. 29, 2004.
9 For a comprehensive survey of European credit reporting systems and their privacy
policies, see Tullio Jappelli and Macro Pagano, “Information Sharing in Credit Markets: The
European Experience,” Working Paper No. 35, Centre for Studies in Economics and
Finance, University of Salerno, March 2000. For more information on Australia’s privacy
policies and the effect on loan rates and credit accessibility, see John M. Barron and
Michael Staten, “The Value of Comprehensive Credit Reports: Lessons from U.S.
Experience,” 2000; online at [www.privacyalliance.org/resources/staten.pdf], visited Jan.
29, 2004.

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possible costs include higher interest rates, reduced accessibility to credit, and a
lower volume of lending activity. Furthermore, some may argue that credit data
limitations bestow anti-competitive advantages to lenders, which can also lead to
higher loan rates and an increased incidence of default.10 The disciplinary effect from
information sharing may also be diminished, resulting in a higher level of consumer
indebtedness and a heightened risk of default. Thus, from this economic perspective,
privacy laws that limit the reporting of credit data could impose significant financial
costs on consumers and the economy as a whole. How these economic costs are
weighed against the benefits of increased financial privacy is a matter for legislative
debate.
This report examines the economics of information sharing in consumer credit
markets by (1) explaining the role of information in the lending process; (2)
describing the economic effects of credit reporting; and (3) outlining the potential
economic benefits forgone by restricting consumer credit information.11
The Role of Information in Credit Markets
In general, the price of a loan is based on the lender’s cost of funds plus a risk
premium. The cost of funds is often linked to a short-term market rate, which
represents a common benchmark for all borrowers regardless of their credit history.
Lenders will often charge an additional risk premium over the market rate as
compensation for bearing the risk of slow, partial, or fully delinquent loan
repayments. Some losses are expected in any risk group of loans and are, in effect,
paid for by the risk premium. The size of this premium depends on the lender’s
ability to properly assess the creditworthiness of the borrower. As a result,
differences across borrowers in the final interest rate charged are based largely upon
the lender’s perceived risk of repayment.12
10 Although the restriction of certain types of credit information may affect the incidence of
default, it is also important to note that default rates are a function of several economic,
legal and regulatory factors. Therefore, one cannot make conclusions about the efficiency
of a credit market based solely on information concerning consumer default rates. A high
incidence of consumer loan defaults does not necessarily imply an inefficient credit market.
11 This report focuses on the potential economic effects of restricting the type of consumer
credit information that is reported between financial institutions and credit reporting
agencies. For an economic analysis of the privacy debate related to the sharing of financial
information among affiliates of the same corporate group, see CRS Report RL31758,
Financial Privacy: The Economics of Opt-In vs Opt-Out, by Loretta Nott.
12 The retail credit card market offers an excellent example of how lenders use risk-based
pricing. The ready availability of comprehensive credit bureau data has allowed card issuers
in the United States to offer their customers an extensive range of products, with different
rates and features, according to the creditworthiness of a borrower. Today, low-risk
borrowers can choose from a wide array of low-rate credit cards. For a detailed explanation
of the evolution of risk-based pricing in the credit card market, see Barron and Staten, “The
Value of Comprehensive Credit Reports: Lessons from the U.S. Experience,” pp. 283-287.

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There are basically two stages to the lender’s assessment process. First, a lender
will screen a credit applicant to judge creditworthiness by gathering information on
the borrower’s characteristics, such as past payment behavior and overall
indebtedness. Second, once the loan has been granted, the lender will monitor the
borrower’s behavior as a means of assessing the risk of default over the term of the
loan. Both stages crucially depend on the lender’s ability to gather accurate and
timely information about an applicant’s borrowing characteristics.
However, this information is typically not freely available to lenders. Borrowers
usually know more than lenders about their willingness and ability to repay a loan.
Thus, it is reasonable to assume that there exists some degree of information
asymmetry between borrowers and lenders. The more accurate information that is
available to lenders, the better they can measure borrower risk and set loan terms
accordingly. Therefore, creditworthy borrowers should want to signal to lenders that
they represent a good credit risk in order to negotiate better loan terms. In contrast,
high-risk borrowers have an incentive to hide their information so as to avoid being
denied or charged more for credit.
When lenders lack the necessary information to distinguish between good and
bad borrowers, it is said that there exist “adverse selection” and “moral hazard”
problems in the market for credit. Adverse selection occurs when a borrower’s
private information about their own credit risk adversely affects uninformed lenders.
For instance, with limited credit information, there are likely to be more bad
borrowers taking loans at any given interest rate. Moral hazard entails hidden
information following the extension of a loan to a borrower. For instance, if a
borrower knows that a lender cannot monitor payment behavior, this can induce the
borrower to make a material change in income or spending that affects their ability
to repay the loan.
To illustrate, suppose that a bank lacked the necessary data to adequately screen
and monitor credit applicants. One possible solution is to raise the interest rate on
loans sufficiently that the bank would be compensated for any loss associated with
lending to a bad borrower. However, a bad borrower will also be the one most likely
to accept a higher interest rate since there is a low probability that the loan will be
repaid. Good borrowers are less likely to apply for credit under such a scenario,
which means that the average riskiness of the borrowing pool will increase, and the
bank will be forced to raise loan rates even more. Furthermore, the higher the
interest rate, the more likely borrowers will reduce their effort to repay the loan,
which in turn, increases the lender’s probability of loss. This will cause the market
to “unravel” and perhaps lead to credit rationing, since information asymmetry
prevents the loan rate from being matched appropriately to actual credit risk.13
There are various ways to mitigate adverse selection and moral hazard problems
in the market for credit. For example, collateral can sometimes be required to secure
a loan in case of nonpayment, so borrowers’ incentives become more aligned with
13 For more information, see Joseph E. Stiglitz and Andrew Weiss, “Credit Rationing in
Markets with Imperfect Information,” American Economic Review, Vol. 71, 1981, pp. 393-
410.

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those of lenders. Indeed, collateral requirements are quite common for high-value
consumer loans, such as mortgages. However, this practice can limit the availability
of credit to those who do not already have substantial assets built up.
Therefore, in addition to collateral requirements, lenders can use information
about a borrower’s characteristics to assess the probability of repayment. Yet each
lender typically has only a piece of the borrower’s overall credit profile. In order to
complete the picture, the lender could face significant search costs. But if lenders
acquire the information by exchanging and pooling it with other lenders, then the
overall picture is allowed to emerge, and each lender has a better means of measuring
a borrower’s creditworthiness. The cost savings to lenders of pooling borrower
information is the motivation for the existence of a credit reporting system.
The Economics of Credit Reporting
Credit bureaus provide the formal mechanism by which lenders can pool and
share information about the characteristics of potential borrowers. Economic theory
predicts that the sharing of this information can have significant effects on lending
activity. First, it mitigates adverse selection problems by improving the lender’s
ability to accurately assess the creditworthiness of borrowers. Second, it reduces the
informational advantages to lenders that can lead to anti-competitive behavior and
moral hazard problems. And third, it discourages consumers from becoming over-
indebted by obtaining credit from multiple lenders. This section will examine each
of these effects in detail.
Mitigates Adverse Selection
Consider a world where banks only have information about the creditworthiness
of their own clients, and consumers deal exclusively with their bank for all their
credit needs. Now suppose an individual applies for credit at Bank A, after being a
previous customer at Bank B. Since Bank A has no information to measure the
applicant’s ability to repay the loan, the bank faces an adverse selection problem.
However, Bank B will have information about the applicant’s borrowing
characteristics. If Bank A and Bank B committed to share this type of information
about their clients, then they would be able to better identify which new applicants
were good credit risks. Since lenders reduce the risk premium they charge for
borrowers with reliable credit histories, information sharing will generally lower loan
rates and the incidence of default at both banks.
Reduces Anti-Competitive Advantages
But why would Bank B want to share this information with Bank A? After all,
Bank B took the initial risk to lend to the applicant the first time, and as a result, has
acquired valuable private information about the customer’s credit risk. Therefore,
Bank B could offer a more competitive loan rate than Bank A or other lenders who
do not possess this information. This informational advantage is said to confer

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market power to Bank B in its pricing of its loans, since with no information sharing
the borrower is likely to face higher rates elsewhere. Thus, Bank B will be reluctant
to lose this competitive advantage by sharing information with Bank A.
Similarly, Bank A has acquired valuable private information about the credit
risk profiles of its own customers, and has the same profit incentive to withhold this
information from Bank B and other lenders. Therefore, each lender in the market
will have a comparative advantage in the pricing of their loans to customers relative
to other lenders, since each lender possesses private information about their own
customers’ borrowing characteristics. In this case, no lender has an incentive to share
information with any other lender. But with no information sharing, each lender can
exercise their market power by charging an inefficiently high loan rate to their
customers, but one that is still below what other lenders are willing to offer to new
clients. If borrowers know that their efforts to establish a good credit history might
not lower their lending rates in the future, they will have a disincentive to repay their
loans in a timely manner today, and in extreme cases, default. As a result, both
default and interest rates will rise in the market.
By committing to share information, lenders are no longer able to unfairly profit
from informational advantages since all lenders have access to the same information.
This commitment is enforced by the development of a formal reporting system, by
which credit bureaus are responsible for the collection, distribution and accuracy of
the information. In contrast to the case without credit reporting, borrowers have an
incentive to signal through their repayment efforts that they are a good credit risk, in
hopes of earning better loan terms in the future. This reduces the probability of
default, which lowers interest rates and increases the total volume of lending.14
Discourages Excessive Consumer Indebtedness
In reality, though, consumers rarely deal with one bank for all their lending
needs. Dealing with several types of lenders encourages competition and lowers the
cost of borrowing to consumers. It also benefits lenders since they bear a smaller
amount of credit risk, which allows them to lower the risk premium included in the
interest rate they charge.
But multiple lending relationships mean multiple loans, and from the
perspective of a lender, a borrower’s ability to repay a loan will also depend on the
individual’s overall indebtedness at the time of repayment. If lenders do not have
information about how much credit a borrower has obtained from various sources,
then consumers will have an incentive to over-borrow, posing a moral hazard risk to
lenders. In response, lenders will either require a higher interest rate to compensate
them for the risk of default, or deny credit altogether. This particular form of moral
hazard is eliminated, however, if lenders agree to exchange information regarding the
amount of credit loaned to borrowers. By knowing a borrower’s total debt burden,
14 For more information, see A. Jorge Padilla and Marco Pagano, “Endogenous
Communication Among Lenders and Entrepreneurial Incentives,” The Review of Financial
Studies, 10(1), Winter 1997, pp. 205-236.

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lenders are able to more accurately measure a borrower’s credit risk today and
monitor the probability of repayment in the future. This is why it is important, as a
matter of economics and finance, for credit bureaus to collect information about how
much credit a borrower has obtained from various lenders.15
The Economic Costs of Credit Data Restrictions
As the previous section discusses, economic theory predicts that there are
distinct benefits from information sharing in credit markets. However, several recent
empirical studies have attempted to test these predictions and quantify the benefits.
The conclusions from this growing body of literature can be summarized as follows:
Lending Volume. Bank lending volumes are greater in countries that have
a greater degree of information sharing.16 There is significant evidence to suggest
that the rapid growth in U.S. credit over the past 35 years is related to public policies
that have promoted comprehensive credit reporting.17 In 2001, U.S. consumer credit
equaled 16.7% of gross domestic product, which is the highest percentage among
most industrialized countries.18
Accessibility. The accuracy and reliability of credit scoring models, the
means by which lenders determine a borrower’s credit risk, crucially relies upon the
amount of consumer credit information available.19 By providing better risk
measuring tools, comprehensive credit data has increased the number of consumers
who now qualify for credit. Furthermore, the national availability of credit
information greatly increases the potential sources of credit to which consumers have
access and offers borrowers a wider array of choice.20
15 For more information, see Tullio Jappelli and Macro Pagano, “Information Sharing in
Credit Markets: A Survey,” Working Paper No. 36, Centre for Studies in Economics and
Finance, University of Salerno, March 2000.
16 For more information, see Tullio Japelli and Marco Pagano, “Information Sharing,
Lending and Defaults: Cross-Country Evidence,” Working Paper No. 22, Centre for Studies
in Economics and Finance, University of Salerno, May 1999.
17 For more information, see John M. Barron and Michael Staten, “The Value of
Comprehensive Credit Reports: Lessons from U.S. Experience.”
18 For more comparative credit statistics, see the European Credit Research Institute website
at [www.ecri.be/statistics2001.html], visited Jan. 29, 2004.
19 For more information, see Gary G. Chandler and Lee E. Parker, “Predictive Value of
Credit Bureau Reports,” Journal of Retailing Banking, Volume XI, 1989, pp. 47-54. Also,
see Gary G. Chandler and Robert W. Johnson, “The Benefit to Consumers from Generic
Scoring Models Based on Credit Reports,” IMA Journal of Mathematics Applied in Business
and Industry, Volume 4, 1992, pp. 61-72, and Information Policy Institute, The Fair Credit
Reporting Act: Access, Efficiency and Opportunity, June 2003, available online at
[http://www.infopolicy.org/pdf/fcra_report.pdf], visited on Jan. 29, 2004.
20 Cate, “Privacy, Consumer Credit, and the Regulation of Personal Information,” pp. 235-
236.

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Delinquency Rates. One study found the use of credit bureau data in credit
scoring models lowers delinquency rates 20-30% more than when lending decisions
are based solely on application data.21 Another study found that delinquencies could
increase by as much as 70% when restrictions on the type of consumer credit data
contained in credit reports reduces the predictive power of standard credit scoring
models.22
Cost of Credit. Securitization, a process by which banks pool consumer loans
and sell them to investors, is dependent upon the complete and accurate credit
information of its clients. Banks use this information to identify and bundle loans
that belong to particular risk groups. This common practice reduces the riskiness of
the bank’s loan portfolio, freeing up capital and reducing the cost of credit.23 One
analyst has estimated that securitization has lowered U.S. mortgage rates by as much
as two full percentage points.24

Thus, recent empirical research suggests that privacy laws that restrict the
reporting of consumer credit data could lead to the potential loss of significant
economic benefits. Credit data limitations may increase the cost of consumer credit,
reduce accessibility and lower the overall volume of lending.
Conclusion
From an economic perspective, the availability of complete and accurate data
on past consumer borrowing behavior is critical for assuring the most efficient
allocation of credit. In the absence of this information, there can exist adverse
selection and moral hazard problems in the market for credit. These problems are
significantly reduced if lenders agree to pool and share information about the
characteristics of potential borrowers. Recent empirical evidence suggests that a
comprehensive credit reporting system reduces the cost of consumer credit, lowers
delinquency rates, improves consumer accessibility to credit, and increases the
overall volume of lending. But in order to enjoy these benefits, consumers give up
some degree of privacy and are exposed to the risks associated with widespread
financial information sharing, such as identity theft. How these risks are weighed
against the economic benefits of a comprehensive credit reporting system is a matter
for legislative debate.
21 For more information, see Peter L. McCorkell, “The Impact of Credit Scoring and
Automated Underwriting on Credit Availability,” in The Impact of Public Policy on
Consumer Credit, Thomas A. Durkin and Michael E. Staten, eds. (Boston: Kluwer
Academic Publishers, 2002), pp. 209-220.
22 Information Policy Institute, The Fair Credit Reporting Act: Access, Efficiency and
Opportunity, p. 9.
23 Cate, “Privacy, Consumer Credit, and the Regulation of Personal Information,” pp. 234-
235.
24 Kitchenman, Walter F., U.S. Credit Reporting: Perceived Benefits Outweigh Privacy
Concerns (Needham, Massachusetts: TowerGroup, 1999), p. 7.