Signaling in Online Credit Markets

This paper studies how signaling can facilitate the functioning of a market with classical adverse selection problems. Using data from Prosper.com, an online credit market where loans are funded through auctions, we provide evidence that reserve interest rates that borrowers post can serve as a signaling device. We then develop and estimate a structural model of borrowers and lenders where low reserve interest rates can credibly signal low default risk. Announcing a high reserve interest rate increases the probability of receiving funding at the cost of higher expected interest payments conditional on obtaining a loan. Borrowers regard this trade-off differentially, which results in a separating equilibrium. Using the estimated parameters of the model, we compare the credit supply curve and welfare under three alternative market designs in our counterfactual policy experiment -- a market with signaling, a market without signaling, and a market with no asymmetric information. We find that the cost of adverse selection can be as much as 16% of the total surplus created under no asymmetric information, up to 95% of which can be restored with signaling. We also estimate the credit supply curves for each of the three market designs and find backward-bending supply curves for some of the markets, consistent with the prediction of Stiglitz and Weiss (1981).