A Note on Information in the Loan Evaluation Process

  • Author(s): BRYAN STANHOUSE, LARRY SHERMAN
  • Published: Apr 30, 2012
  • Pages: 1263-1269
  • DOI: 10.1111/j.1540-6261.1979.tb00072.x

Undoubtedly, one of the most important decisions linking durable consumption spending and investment behavior to future income is the extension of bank credit. Surprisingly, little analytical work has addressed the credit evaluation process and, specifically, the need of the lending authority to assimilate information in order to assess the likelihood of repayment. The purpose of this note is to construct a model of lender utility maximization which explicitly accounts for the assimilation of information as an input to the decision‐making process.

Aigner and Sprenkle [2] were the first to develop a model of optimal short run lending behavior in the context of variable information, an objective that this note clearly shares. However, Aigner and Sprenkle's research results were constrained by their use of an ad hoc information function. We employ a Bayesian approach to the information demand decision which allows the lender to revise the expected return and the variance of the return with the acquisition of additional customer information. Our method of analyzing the information demand decision is an application of Kihlstrom's work [11] on the theory of information demand.

In section I, the role of information in adjusting the expected utility associated with each lending decision is established. In section II, we derive the lender's optimal loan size. The basis for section III is a proof of the existence of an optimal demand for information and an analysis of this demand in regard to other important variables. In section IV, we summarize the major conclusions relating to credit extension and the demand for information about the credit worthiness of a loan applicant.

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