Perverse cross-subsidization in the credit market
We show how asymmetric information and borrowers' heterogeneity in wealth may produce equilibria in which, due to decreasing absolute risk aversion, hard working poor borrowers subsidize richer borrowers. In particular, a model of adverse selection and moral hazard in a competitive credit market is developed with private information on borrowers' wealth. Because of the ambiguous e¤ect of decreasing risk aversion on the willingness to post collateral, both separating and pooling equilibria are possible in principle. Under separation the poor borrowers bear the cost of separation in terms of excessive risk taking. In a more likely pooling equilibrium poor hard-working borrowers subsidize richer ones.
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