Journal of Real Estate Finance and Economics, 29:1, 5±46, 2004
# 2004 Kluwer Academic Publishers. Manufactured in The Netherlands.
Discrimination in Lending: Theory and Evidence*
Federal Reserve Board, Washington, D.C., U.S.A.
Using a general equilibrium model of credit market discrimination, I ®nd that both taste-based discrimination and
statistical discrimination have similar predictions for the intergroup differences in loan terms. The commonly
held view has been that if taste-based discrimination exists, loans approved to minority borrowers will have
higher expected pro®tability than those to majorities with comparable credit background. I show that the validity
of this pro®tability view depends crucially on how expected loan pro®tability is measured. I also show that taste-
based discrimination must exist if loans to minority borrowers have higher expected rates of return or lower
expected rates of default loss than those to majorities with the same exogenous characteristics observed by lender
at the time of loan originations. My analysis suggests that the valid method to test for taste-based discrimination
should be reduced-form regressions. Empirically, I fail to ®nd supporting evidence for the existence of taste-based
Key Words: economics of discrimination, mortgage lending, default
Access to credit markets is vital to both individual economic welfare and aggregate
economic growth. As a result, regulators, practitioners, researchers, and the public have
been interested in the potential contribution of discrimination to the imperfect access to
credit markets by minorities. In recent years, concerns over credit market discrimination
have intensi®ed as a number of studies have documented signi®cantly higher rejection
rates among black and Hispanic loan applicants than among whites with the same
observable characteristics (e.g., Black et al., 1978; Schafer and Ladd, 1981; Duca and
Rosenthal, 1993; Munnell et al. 1996; Dymski, 2001; Cavalluzzo et al., 2002). Critics
question data quality and empirical methods of these studies. Critics also argue that the
observed racial disparity in rejection rates may be caused by statistical discrimination, as
opposed to prejudice, or taste-based discrimination. Statistical discrimination is a practice
in which a lender, lacking full information on a borrower's creditworthiness, applies group
stereotypes to individual borrowers in evaluating loan applications (Arrow, 1972; Phelps,
Since both statistical and taste-based discrimination imply higher rejection rates
for minority applicants, rejection rate is not a reliable measure of taste-based
discrimination in lending.
*The views expressed herein are those of the author and do not necessarily re¯ect the views of the Board nor the
staff of the Federal Reserve System.