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Models of optimal contract in lending: Evaluating the impact of diversified versus focused policies on riskiness of borrower base

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  • Firoozi, Fathali
  • Lien, Donald

Abstract

Empirical studies on bank lending policies have offered contradictory results regarding the impact of each of the two distinct lending policies of focused and diversification on riskiness of lender’s borrower base. This study first constructs a general model of contracts for lending under asymmetric information and characterizes the equilibrium outcomes under each of the two lending policies. It then demonstrates that the relative preferences of borrower groups towards bank loan plays a key role in determining if a lending policy switch between the two policies increases or decreases the riskiness of the bank’s borrower base. The results offer a rational explanation for the existing contradictory results in the empirical literature.

Suggested Citation

  • Firoozi, Fathali & Lien, Donald, 2022. "Models of optimal contract in lending: Evaluating the impact of diversified versus focused policies on riskiness of borrower base," The North American Journal of Economics and Finance, Elsevier, vol. 63(C).
    • Handle: RePEc:eee:ecofin:v:63:y:2022:i:c:s1062940822001450
    DOI: 10.1016/j.najef.2022.101810
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    References listed on IDEAS

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    More about this item

    Keywords

    Asymmetric information; Borrower risk; Likelihood ratio measure of risk;
    All these keywords.

    JEL classification:

    • C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G2 - Financial Economics - - Financial Institutions and Services

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