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Competition in Lending: Theory and Experiments

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  • Elena Asparouhova
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    Abstract

    A variation of the Rothschild-Stiglitz' equilibrium is examined in the context of competitive lending under adverse selection. The predictions of the model are tested in an experimental market setting. If equilibrium exists, the loan contracts offered and taken should separate projects by quality. When equilibrium exists, the experiments confirm the theory. The entrepreneurs with high-risk projects take bigger loans and pay higher credit spreads than those with low-risk projects. When equilibrium does not exist, which happens exactly when the candidate equilibrium does not provide a Pareto-optimal allocation, in half of the sessions loan trading stabilizes around the candidate equilibrium pair. In the other half, however, markets never settle down. This finding has important implications. When lenders can offer menus of contracts, as is usually the case in reality, the outcome may not be the zero-profit separating contracts of the standard model. Worse, fitting the standard model to field data may lead to serious biases in estimated parameters while falsely accepting the model's main restriction (separation). Copyright 2006, Oxford University Press.

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    File URL: http://hdl.handle.net/10.1007/s10679-006-8280-8
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    Bibliographic Info

    Article provided by European Finance Association in its journal Review of Finance.

    Volume (Year): 10 (2006)
    Issue (Month): 2 ()
    Pages: 189-219

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    Handle: RePEc:oup:revfin:v:10:y:2006:i:2:p:189-219

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    Cited by:
    1. Eva I. Hoppe & Patrick W. Schmitz, 2013. "Contracting under Incomplete Information and Social Preferences: An Experimental Study," Review of Economic Studies, Oxford University Press, vol. 80(4), pages 1516-1544.
    2. Elena Asparouhova & Peter Bossaerts & Jernej Copic & Brad Cornell & Jaksa Cvitanic & Debrah Meloso, 2012. "Competition in Portfolio Management: Theory and Experiment," Working Papers 438, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    3. Elena Asparouhova & Peter Bossaerts & Nilanjan Roy & William Zame, 2013. "'Lucas' In The Laboratory," NBER Working Papers 19068, National Bureau of Economic Research, Inc.
    4. repec:nbr:nberch:12923 is not listed on IDEAS

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