Debt Contracts, Collapse and Regulation as Competition Phenomena

This paper studies a credit market with adverse selection and moral hazard where sufficient sorting is impossible. The crucial novel feature is the competition between lenders in their choice of contracts offered. The quality of investment projects is unobservable by banks and entrepreneurs’ investment decisions are not contractible, but output conditional on investment is. The paper explains the empirically observed prevalence of debt contracts as an equilibrium phenomenon with competing lenders. Equilibrium contracts must be immune against raisin-picking by competitors. Non-debt contracts allow competitors to offer sweet deals to particularly good debtors, who will self-select to choose such a deal, while bad debtors distribute themselves across all offered contracts. Competition between banks introduces three possibilities for a breakdown of credit markets which do not occur when a bank has a monopoly. First, average returns decrease since banks compete for good lenders, which may make lending altogether unprofitable. Second, banks can have an incentive to offer a debt contract and additional equity contracts to intermediate debtors, which is in turn dominated by a simple debt contract, only attractive for very good entrepreneurs. As a result, no equilibrium in pure strategies exists. Existence can be restored in this scenario if the permissible types of contracts are limited by regulation resembling the separation of investment and commercial banking in the United States. Finally, allowing for random delivery on credit contracts leads to a breakdown since all banks seek to avoid the contract with the highest chance of delivery: that contract attracts all bad entrepreneurs.