Abstract
We analyze the impact of bank competition on the equilibrium quality of loans in a formal model where banks do not observe the type of loan applicants, i.e. face an adverse selection problem, nor borrowers’ effort, i.e. also face a moral hazard problem. The main finding is that there exists an inverted U-shaped relationship between competition and the average quality of loans. Policy implications are derived from this result and from an extension to the basic model where banks may sequentially acquire information about potential borrowers.
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Notes
Refer to Section 2 for a revision of related theoretical and empirical work.
We use the term “fake entrepreneurs” to refer to those potential borrowers that will never be able to repay loans.
While other specifications of imperfect competition may be relevant for the banking industry, assuming Cournot competition is convenient for a number of reasons. First, it allows us to formalize the problem in a relatively simple way. Second, the level of competition is completely summarized by the number of banks in the market. Third, modeling competition à la Cournot allows us to have an equilibrium in pure strategies (see Von Thadden 2004, for a discussion on equilibrium outcomes when competition is à la Bertrand). In addition to that, it is worth to say that Cournot competition is also assumed in the related literature (see for instance Allen and Gale 2000; Boyd and De Nicolo 2005; Martinez-Miera and Repullo 2010).
We use the terms “an entrepreneur that is endowed with a type Θ technology” and “a type Θ entrepreneur” interchangeably. We also refer to those “entrepreneurs that are endowed with a type L technology” as “fake” entrepreneurs.
The qualitative results of our model remain unchanged if we assume that the type L investment technology yields anything lower than the required up-front investment, i.e. 0 < R L < 1, but the algebra is more complicated.
In this model, banks can provide information about the total indebtedness, and even about the result of the test of each borrower that has obtained a loan, to a public credit register. The important feature is, however, that banks do not observe how many times the application of a potential borrower for a loan has been rejected by other banks. We come back to the discussion of this point in Section 7.
This can be supported on the existence of a public credit register with information about the total indebtedness of each borrower. So, banks know who have obtained loans and do not lend further amounts to them.
In the basic model function f depends on the number of banks in the market, N, through the probability of granting a loan to a High-technology entrepreneur, which is denoted by β(N).
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Acknowledgements
Authors would like to thank Ana Balsa, George Bulkley, Marcelo Caffera, David De-Meza, Juan Dubra, Xavier Freixas, CarlosMontoro, Enrico Perotti, Jean-Charles Rochet, Javier Suarez, Danilo Trupkin, Leandro Zipitria, Felipe Zurita and an anonymous referee for their valuable comments and fruitful discussions.
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The views expressed herein are those of the authors and do not necessarily represent the views of the institutions to which they are affiliated. Part of this research was conducted when Gomez was a graduate student at Toulouse School of Economics.
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Gomez, F., Ponce, J. Bank Competition and Loan Quality. J Financ Serv Res 46, 215–233 (2014). https://doi.org/10.1007/s10693-013-0179-x
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DOI: https://doi.org/10.1007/s10693-013-0179-x