This paper explores a two-bank model in which, first, one bank correctly estimates the probability of low-quality loan repayment while the other overestimates it, and second, both banks have identical convex costs when granting loans. In this context of optimistically biased banking competition, we show how the unbiased bank follows the biased competitor as long as the bias of the latter is not too large. This would favour bad borrowers, who get better credit conditions at the expense of good borrowers. As a consequence, the presence of a biased bank increases welfare as long as the expected default rate is sufficiently high. Contrariwise, in subprime markets, biased banking competition would be socially harmful.
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The authors would like to thank Steffen Hoernig (the Editor) and two anonymous reviewers for the fruitful suggestions provided. In addition, the authors gratefully acknowledge the financial support received from the Xunta de Galicia (Spain) through Research Project ED431B2016/001 Consolidación e estruturación – 2016 GPC GI-2016 Análise económica dos mercados e institucións. This research has also received the funding of the Program for the “Consolidation and Structuring of Competitive Research Units - Research Networks (Redes de Investigación)” (Ref. ED341D R2016/014), Proxectos Plan Galego IDT, from the Xunta de Galicia (Spain).
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