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Project Monitoring and Banking Competition under Adverse Selection

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Author Info
Vesa Kanniainen
Rune Stenbacka

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Abstract

We develop an analysis of ex ante monitoring of risky projects in banking. If protected from competition, banks are more concerned about not catching good risk projects when the perceived state of the economy improves, while they are more concerned about being induced to finance bad risk projects when conditions deteriorate. A monopoly bank provides the socially optimal ex ante monitoring of good risks, but is too conservative with regard to bad risks. Competition between banks is shown to undermine the incentives to avoid decision errors regarding both good and bad risk projects providing too limited monitoring effort from society's point of view.

ZUSAMMENFASSUNG - (Projektsteuerung und Bankenwettbewerb bei adverser Selektion)
In dem Beitrag wird ein Modell zur Auswahl von risikobehafteten Projekten durch Banken entwickelt. Wenn Banken vor Wettbewerb geschützt werden, dann legen sie unter guten wirtschaftlichen Bedingungen mehr Wert darauf sich keine Projekte mit gutem Risiko entgehen zu lassen, wohingegen sie, wenn sich die Bedingungen verschlechtern eher darauf achten keine schlechten Projekte zu finanzieren. Eine monopolistische Bank leistet die sozial-optimale Auswahl guter Risiken, aber die Selektion ist zu konservativ im Hinblick auf schlechte Risiken. Es wird gezeigt, daß Wettbewerb zwischen den Banken dazu führt, daß die Anreize fehlerhafte Entscheidung zu vermeiden sowohl im Hinblick auf Projekte mit guten als auch für Projekte mit schlechten Risiken zu gering sind. Die gesellschaftliche Wohlfahrt sinkt, weil Banken zu wenig in Projektauswahl investieren.

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Publisher Info
Paper provided by Wissenschaftszentrum Berlin (WZB), Research Unit: Competition and Innovation (CIG) in its series CIG Working Papers with number FS IV 97-23.

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Length: 37 pages
Date of creation: Oct 1997
Date of revision: Oct 1998
Handle: RePEc:wzb:wzebiv:fsiv97-23

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Related research
Keywords: bank monitoring; adverse selection; banking competition; banking crisis;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Diamond, Douglas W, 1991. "Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 689-721, August. [Downloadable!] (restricted)
  2. Boyd, John H & Smith, Bruce D, 1993. "The Equilibrium Allocation of Investment Capital in the Presence of Adverse Selection and Costly State Verification," Economic Theory, Springer, vol. 3(3), pages 427-51, July.
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  3. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August. [Downloadable!] (restricted)
  4. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 393-414, July. [Downloadable!] (restricted)
  5. Broecker, Thorsten, 1990. "Credit-Worthiness Tests and Interbank Competition," Econometrica, Econometric Society, vol. 58(2), pages 429-52, March. [Downloadable!] (restricted)
  6. De Meza, David & Webb, David C., 1988. "Credit market efficiency and tax policy in the presence of screening costs," Journal of Public Economics, Elsevier, vol. 36(1), pages 1-22, June. [Downloadable!] (restricted)
  7. Franklin Allen & Andrew Winton, . "Corporate Financial Structure, Incentives and Optimal Contracting (Reprint 049)," Rodney L. White Center for Financial Research Working Papers 15-94, Wharton School Rodney L. White Center for Financial Research.
  8. Caminal, Ramón & Matutes, Carmen, 1997. "Can Competition in the Credit Market be Excessive?," CEPR Discussion Papers 1725, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September. [Downloadable!] (restricted)
  10. Chan, Yuk-Shee & Greenbaum, Stuart I. & Thakor, Anjan V., 1986. "Information reusability, competition and bank asset quality," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 243-253, June. [Downloadable!] (restricted)
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  11. Boot, Arnoud W A & Thakor, Anjan, 1997. "Can Relationship Banking Survive Competition?," CEPR Discussion Papers 1592, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  1. Ramon Caminal & Carmen Matutes, 2002. "Can competition in the credit market be excessive?," UFAE and IAE Working Papers 527.02, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC). [Downloadable!]
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