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Undergraduate Economic Review

Abstract

This paper seeks to address the risks of extending credit to those without collateral through a game theory analysis. There is relatively low risk when lending to someone with collateral, such as a house or a car, however a potential borrower without collateral is seen as a much larger risk. The three major issues of lending: Moral Hazard, Adverse Selection and Enforcement are seen as the three main obstacles that must be overcome and addressed for credit to be available to those without collateral. As will be displayed throughout this paper, there are not three issues that must be addressed, but rather, one. The single issue of extending credit to the collateral-less is enforcement. By addressing the issue of enforcement, both moral hazard as well as adverse selection are addressed. The rationale behind this is that when there is full enforcement capability by the lender (Guaranteed Repayment), the issue of moral hazard is addressed and the issue of asymmetric information becomes relatively insignificant. Moral hazard is addressed in two ways: First, the borrower understands that they will be forced to repay the loan which creates incentives for the borrowers to abstain from utilizing credit for endeavors that previously they would have been limited in liability for. A good example of this is student loans; students don’t take out loans with the assumption that they can default and file for bankruptcy to remedy their debts because under U.S. law they are unable to do so. Secondly, the lenders are aware of the game facing the borrowers, and therefore they can assume that any borrower attempting to utilize credit is risky due to moral hazard, which increases the borrowers’ ability to extend credit. Adverse selection and asymmetric information become relatively unimportant because there cannot be negative implications from asymmetric information if there is full enforcement capability. This holds true in two ways: First off, if someone has asymmetric information that makes likely to default on their loan, it makes no difference because they will still be forced to repay. Secondly, if they have asymmetric information which makes their payoffs higher than the lender is aware of, it is not valuable to keep this as asymmetric information because it benefits both the lender and the borrower, and therefore the potential borrower would make that information known to the lender. When comparing a government backed lending entity versus a private lending entity, as well as in comparing a corrupt government backed entity to a non-corrupt government backed entity utilizing a potential borrower without collateral, game theory allows us to draw conclusions on solutions to social dilemmas within lending. All games were three-player, multi-strategy games with expected payoffs represented in the present value of the long term. Nature was brought into each game to represent the uncertainty that is associated with all credit transactions. The four games solutions supported the hypothesis of enforcement being the singular issue when analyzing whether to or not to extend credit to a collateral-less borrower. When investigating the effects of corruption, expected payoff functions were utilized to assess the incentives to seek rents by government backed entities in comparison to a private entity. Additionally, assessing the ability of the borrower to identify rent-seeking in the market for credit was assessed to see the costs and benefits of a private entity relative to a government backed entity. After concluding these studies, it became apparent that enforcement was the key issue to collateral-less borrowing, but also, that there would be less corruption with a government backed entity than a private entity, due to the relative expected payoffs of corrupt behavior.

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