Competition is usually good for consumers, pushing prices down. For US car buyers with less than sterling credit, however, too much competition among lenders tends to drive interest rates up, according to Chicago Booth’s Constantine Yannelis and Anthony Zhang.

Their counterintuitive finding reflects the high fixed costs of screening borrowers, the researchers argue. As the number of institutions competing for car loan business rises, each lender’s market share shrinks, leaving less incentive to invest in assessing the risk of default among borrowers with lower credit ratings. So lenders jack up rates in the subprime segment, the research suggests.

“In this market, the economic forces are working against the weakest segment of society—those who can least afford to pay the most,” says Zhang. “Regulators need to realize that in this market, competition simply doesn’t work for subprime borrowers.” For policy makers, the finding suggests that some level of concentration in this banking segment may be better for consumers, the researchers write.

Yannelis and Zhang studied the car loan market because it’s large and largely free from government intervention, making competition a first-order concern. Auto loans total $1.4 trillion in the United States, ranking behind only mortgages and student loans, according to the Federal Reserve. In the past two years, 85 percent of all new vehicle sales and just over half of used vehicle deals involved auto loans, the National Automobile Dealers Association estimates.

The researchers base their findings on data from the TransUnion Consumer Credit Panel housed at Chicago Booth’s Kilts Center for Marketing. The records represent a 10 percent sample of all car loans—balances, scheduled payments, and loan maturity—in the US between 2009 and 2020. They also include VantageScore, a proprietary consumer credit rating model that ascribes a numerical score to each borrower on the basis of the likelihood of default.

A tale of two borrowers

Borrowers with the lowest credit scores were charged car loan interest as much as six times higher than those with the top ratings, the study finds. Subprime consumers with scores between 300 and 550 paid anywhere from 17 percent to 18.5 percent. Meanwhile, prime borrowers paid between 4.5 percent and 5.5 percent. Those with scores of 750 or higher got rates of 3.5 percent or lower.

The researchers also analyzed the effects of industry concentration on car loan rates using Federal Reserve data along with the Herfindahl-Hirschman Index, which measures the competitiveness of a market or industry. They find that between 2009 and 2019 there were 1,442 bank mergers affecting 1,812 counties. Their modeling demonstrates that for borrowers with the lowest credit scores, rates increased as competition intensified, whereas for those with better scores, more competition correlated with lower rates.

As fewer players controlled more of the market over time, Yannelis and Zhang find no evidence of rising interest rates, particularly for subprime borrowers. This, they argue, is because less market competition enabled banks to spend more on sophisticated screening mechanisms. They were also better positioned to simply restrict credit to consumers who were more likely to default.

“Our results have implications for competition policy in lending markets,” the researchers write. “Competition appears not to improve market outcomes in subprime credit markets, so antitrust regulators may want to allow some amount of concentration in these markets.”

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