Friday, May 4, 2012
Michael Simkovic (Seton Hall), Risk-Based Student Loans:
Credit markets serve a vital function in capitalist economies: evaluating the riskiness of a range of possible investments and channeling resources toward those investments that investors believe are most likely to prove successful. This process is known as the “risk-based pricing” of credit. Ideally, risk-based pricing should lead to lower cost of capital for lower risk investment choices, and therefore more investment in such promising activities. Conversely, risk-based pricing should lead to higher costs of capital, and therefore less investment, in high-risk activities. If creditors are well informed and analytic, and borrowers respond to financial incentives, then risk-based pricing — compared to uniform credit pricing — leads to a more efficient allocation of society’s limited resources.
Although risk-based pricing is standard in business loan markets, and is increasingly common in consumer credit markets such as mortgages and credit cards, risk-based pricing is rare in the market for student loans. The reasons for the rarity of risk-based pricing in the student loan market include limitations of the available data, bankruptcy and collections laws that shift default risk from student loan lenders to borrowers, and moral and philosophical beliefs about the primacy of individual choice and the role of education as an engine of equal opportunity.
This article argues that the lack of risk-based pricing in student loans may ultimately undermine many of the interests and values that uniform student loan pricing ostensibly seeks to promote. Without risk-based pricing of student loans, there may be no reliable price signal about the long-term financial risks inherent in different courses of study. This lack of price signals undermines students’ ability to make informed decisions about the course of study that will best balance their innate abilities and individual preferences with postgraduate economic opportunities. Similarly, the lack of price signals may undermine post-secondary educational institutions’ ability to adjust their programs to improve their students’ postgraduate prospects. Misallocation of educational resources is not only harmful to individual students and their families — it could threaten to undermine the productivity and competitiveness of the U.S. labor force and the U.S.’s ability to continue to invest in education and research.
Transparent, risk-based student loan pricing could greatly benefit students and educational institutions, particularly if it were data-driven and sensitive to the values of equal opportunity and independent research that are central to the academic enterprise. This article discusses legal and policy reforms that could facilitate risk-based student loan pricing, potential hazards from a shift toward risk-based pricing, and safeguards that could help protect students and educators from abuse.