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Lender deception as a response to moral hazard

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Abstract

The paper considers a principal–agent relationship between a borrower and lender based on a model from Bowles (Microeconomics: behavior, institutions, & evolution. Princeton University Press, Princeton, 2003). It expands the model by incorporating borrower collateral as an exogenous variable to partly assuage lender concerns about excessive risk, and a theory of lender deception is then developed. Deception is posited as a costly activity that effectively makes fraud undetectable and extracts the borrower’s economic rent arising from moral hazard despite the presence of third-party enforcement and borrower collateral. We identify under what conditions a lender may have sufficient incentives for employing deception and to what extent they would employ it. The likelihood of, and outcomes from, deception are compared between monopoly lenders those in competitive markets. The model suggests that competitive lenders have more incentive to deceive than a monopoly lender facing the same borrower.

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Notes

  1. The most obvious example is insurance fraud; see Picard 1996, 2000a, b, or Crocker and Morgan (1998) as examples of this literature. See Darby and Karni (1973) for an example where fraud is a choice variable of the agent, and see Lacker and Weinberg (1989) for optimal contracts where monitoring/enforcement is costly.

  2. See, for example, Carr and Kolluri (2001), Eggert (2004), Engel and McCoy (2005), and Renuart (2004).

  3. See, for example, Nichols et al. (2000), Nichols et al. (2005), Cutts and Van Order (2005), Pennington (2002), and Pennington-Cross (2003). See Leece (2004) for an overview of mortgage market models.

  4. They refer to this as “informed investor” approaches; some examples of this literature are Garmaise (2001), Bernhardt and Krasa (2004), Villeneuve (2005), and Manove et al. (2001).

  5. It is worth noting that in Bowles (2003) the level of risk and the level of effort undertaken by the borrower are both represented by \(f\). Bowles proposes that we think of the project as ‘a machine’ that can be run at higher speeds (level of effort) but at a greater risk of breaking-down (risk of failure). Since most models of moral hazard in credit markets refer to a level of risk, we will primarily refer to \(f\) as the risk undertaken by the borrower.

  6. Note that, while there are stages to this interaction, time is not an explicit element of the contract and \(r\) as it is used here is not limited to [0,1], since the total interest paid after the successful completion of the project may exceed the principal borrowed. Also, in the foregoing analysis we will more often refer to, not the interest rate, but the interest factor, \(\delta \).

  7. While it is technically not defining levels of the profit rate, but levels of the rate of expected repayment, we will refer to these level-curves as iso-profit curves.

  8. This suggests that deception is doubly advisable (!) to the monopolist lender: pretend to be a competitive lender and employ deception against the borrower. But this also suggests another possible approach to the concept of deception: since the maximal profit possible with a borrower is where the iso-profit curve is tangent to the participation constraint in \((\delta ,f)\) space, the deceptive lender could set the perceived interest factor at a level where \(\pi <\pi _{o}\), then deceptively charge \(\delta _{\pi }\).

  9. This point is owed to an observation made by Markus Schneider.

  10. This may be in part due to the reduction in rent through repeated interaction (see Spear and Sanjay (1987)). Bowles (2003) also uses another version of this model to demonstrate the rent-reducing effects of repeated interaction.

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  1. Department of Economics, New York University, 19 W. 4th St., 6th Floor, 10012 , New York, NY, USA

    Ross A. Tippit

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Correspondence to Ross A. Tippit.

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I am grateful for the comments of many readers, especially Duncan Foley and three anonymous referees. The usual disclaimer applies.

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Tippit, R.A. Lender deception as a response to moral hazard. J Econ 113, 59–77 (2014). https://doi.org/10.1007/s00712-013-0364-2

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  • DOI: https://doi.org/10.1007/s00712-013-0364-2

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