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Loans, Insurance and Failures in the Credit Market for Students

  • Elena Del Rey
  • Bertrand Verheyden

Whereas public student loans are often income contingent, private banks typically offer pure loans, or don't offer loans at all. In order to provide a rationale for these observations, we present a model with perfectly competitive banks and risk averse students who have private information on their ability to learn. We show that the combination of ex-post moral hazard and adverse selection produces credit market rationing when default penalties are low. Intermediate levels of default penalties can result in the existence of an equilibrium that pools together ability types. However, pooling contracts are not insuring at equilibrium, which implies a second type of credit market failure. Finally, if default penalties are large enough, equilibrium contracts provide less able students with insurance against the eventuality of a bad outcome, just in the income contingent loan fashion. The model is also used to explain other stylized facts, such as the positive impact of returns to education and interest rate subsidies on the development of the student loan market. Also, it explains why, unlike banks, governments oer income contingent loans.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 359.

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Date of creation: Aug 2008
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Handle: RePEc:bge:wpaper:359
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  1. Lance J. Lochner & Alexander Monge-Naranjo, 2010. "The Nature of Credit Constraints and Human Capital," University of Western Ontario, CIBC Centre for Human Capital and Productivity Working Papers 20101, University of Western Ontario, CIBC Centre for Human Capital and Productivity.
  2. Bas Jacobs & Sweder J. G. van Wijnbergen, 2007. "Capital-Market Failure, Adverse Selection, and Equity Financing of Higher Education," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 63(1), pages 1-32, March.
  3. Hung-ju Chen, 2003. "Educational Systems, Growth and Income Distribution: A Quantitative Study," Computing in Economics and Finance 2003 13, Society for Computational Economics.
  4. Timothy J. Kehoe & David K. Levine, 1992. "Debt constrained asset markets," Working Papers 445, Federal Reserve Bank of Minneapolis.
  5. Canton, Erik & Blom, Andreas, 2004. "Can student loans improve accessibility to higher education and student performance? An impact study of the case of SOFES, Mexico," Policy Research Working Paper Series 3425, The World Bank.
  6. David, DE LA CROIX, 2004. "Education and Growth with Endogenous Debt Constraints," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 2004020, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  7. de Meza, David & Webb, David C, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 281-92, May.
  8. Zeira, Joseph, 1991. "Credit Rationing in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 32(4), pages 959-72, November.
  9. Chapman, Bruce, 2006. "Income Contingent Loans for Higher Education: International Reforms," Handbook of the Economics of Education, Elsevier.
  10. Bruce Chapman & David Greenaway, 2006. "Learning to Live with Loans? International Policy Transfer and the Funding of Higher Education," The World Economy, Wiley Blackwell, vol. 29(8), pages 1057-1075, 08.
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