We study a competitive credit market in which lenders with partial knowledge of loan repayment use one of three decision criteria – maximization of expected utility, maximin, or minimax regret – to make lending decisions. Lenders allocate endowments between loans and a safe asset, while borrowers demand loans to undertake investments. Borrowers may incompletely repay their loans when investment productivity turns out to be low ex post. We characterize market equilibrium, the contracted repayment rate being the price variable that equilibrates loan supply and demand. Supposing that a public Authority wants to maximize the net social return to borrowing, we study two interventions in the credit market to achieve this objective. One intervention manipulates the return on the safe asset and the other guarantees a minimum loan return to lenders. In a simple scenario, we find that manipulation of the return on the safe asset can be an effective way to achieve the socially desired outcome if lender beliefs about the return to lending are not too pessimistic relative to the beliefs of the Authority. Contrariwise, guaranteeing a minimum loan return can be effective if lender beliefs are not too optimistic relative to the beliefs of the Authority.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
14378.
Length: Date of creation: Oct 2008 Date of revision: Handle: RePEc:nbr:nberwo:14378
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Find related papers by JEL classification: E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation H81 - Public Economics - - Miscellaneous Issues - - - Governmental Loans and Credits
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