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Lending to uncreditworthy borrowers

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  • Sengupta, Rajdeep

Abstract

We study optimal lending behavior in situations where borrowers’ outside options increase with their creditworthiness. Creditworthiness is private information of borrowers. Lenders use collateral as a screening mechanism to address this adverse selection problem. A lender seeking to attract creditworthy borrowers with high reservation payoffs (while screening out uncreditworthy types) must offer contracts with sufficiently low interest rates and, consequently, high collateral requirements. Because higher collateral requirements raise screening costs, however, lenders favor pooling uncreditworthy borrowers over screening them—in essence, a lowering of credit standards. Lending costs determine break-even offers that rival incumbents can offer borrowers. Accordingly, a lender faces borrowers whose reservation payoffs depend on the lender’s cost advantage over rival incumbent lenders. Our results imply that screening is more likely to occur in markets with a greater disparity in lending costs. Conversely, when funding markets are intensely competitive, lenders are more likely to resort to pooling. This paper also rationalizes the phenomenon of cream-skimming by outside (foreign) lenders as an equilibrium of the model. Surprisingly, we find that the presence of an informed rival actually facilitates cream-skimming by an uninformed lender.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 23 (2014)
Issue (Month): 1 ()
Pages: 101-128

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Handle: RePEc:eee:jfinin:v:23:y:2014:i:1:p:101-128

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Web page: http://www.elsevier.com/locate/inca/622875

Related research

Keywords: Bank competition; Credit allocation; Lending standards;

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References

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Cited by:
  1. Gabriel Jiménez & Steven Ongena & José Luis Peydró & Jesús Saurina, 2009. "Hazardous times for monetary policy: What do twenty-three million bank loans say about the effects of monetary policy on credit risk-taking?," Banco de Espa�a Working Papers 0833, Banco de Espa�a.

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