A Simulation Model for Risk and Pricing Competition in the Retail Lending Market

Abstract

We propose a simulation model of the retail lending market with two types of agents: borrowers searching for low interest rates and lenders competing through risk-based pricing. We show that individual banks observe adverse selection, even if every lender applies the same pricing strategy and a credit scoring model of comparable discrimination power. Additionally, the model justifies the reverse-S shape of the response rate curve. According to the model, the benefits of even small increases in the discrimination power of credit scoring are substantial. This effect is more pronounced if the number of offers checked by the applicants before making a decision increases. The simulations illustrate the trade-off between profitability, market share, and credit loss rates. The profit-maximising strategy is to set interest rates slightly lower than the competition; the excessive price reduction turns out to be counterproductive. At the same time, there exists a niche for higher yield players.