Think of a credit market with a good borrowers and 1 - a bad borrowers. The good borrowers are all identical, and always repay their loans. Bad borrowers never repay their loans. Banks issue deposits that pay a real interest rate r_1, and make loans to borrowers. Banks cannot tell the difference between a good borrower and a bad one. Each borrower has H units of collateral, which is an asset with unit value p in the future period. Define the default premium (DP) as the difference between the borrowing rate (r_2) and the savings rate (r_1), so that: DP = r_2 - r_1