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Asymmetric information in credit markets and entrepreneurial risk taking

  • Vesala , Timo

    (RUESG, , University of Helsinki)

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    The paper constructs a search-theoretic model of credit markets with a bilateral trading mechanism that enables the manageable introduction of asymmetric information. Borrowers´ success probabilities are unobservable to financiers, but the degree of risk in observable projects can be used as a sorting device. We find that the efficiency of a perfect Bayesian equilibrium depends negatively/positively on the credit market ´tightness´/liquidity. In general equilibrium, where the underlying market conditions are endogenously determined, steady states with greater credit market tightness are always associated with increasingly excessive investment in risky projects. Since tighter market conditions also imply less intense competition among financiers, the commonly asserted trade-off between competition and efficiency does not emerge. Tighter monetary policy is shown to worsen the adverse effect of informational frictions on efficiency.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0414.pdf
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    Paper provided by Bank of Finland in its series Research Discussion Papers with number 14/2004.

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    Length: 35 pages
    Date of creation: 14 Jul 2004
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2004_014
    Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/

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    1. Matutes, Carmen & Vives, Xavier, 1995. "Imperfect Competition, Risk Taking, and Regulation in Banking," CEPR Discussion Papers 1177, C.E.P.R. Discussion Papers.
    2. Bester, Helmut, 1988. "Bargaining, Search Costs and Equilibrium Price Distributions," Review of Economic Studies, Wiley Blackwell, vol. 55(2), pages 201-14, April.
    3. Tuomas Takalo & Otto Toivanen, 2004. "Equilibrium in financial markets with adverse selection," Finance 0405001, EconWPA.
    4. Zsolt Becsi & Victor Li & Ping Wang, 2000. "Financial Matchmakers in Credit Markets with Heterogeneous Borrowers," Vanderbilt University Department of Economics Working Papers 0032, Vanderbilt University Department of Economics.
    5. Laing, Derek & Palivos, Theodore & Wang, Ping, 1995. "Learning, Matching and Growth," Review of Economic Studies, Wiley Blackwell, vol. 62(1), pages 115-29, January.
    6. repec:cup:cbooks:9780521576475 is not listed on IDEAS
    7. Rubinstein, Ariel, 1982. "Perfect Equilibrium in a Bargaining Model," Econometrica, Econometric Society, vol. 50(1), pages 97-109, January.
    8. Diamond, Peter, 1990. "Pairwise Credit in Search Equilibrium," The Quarterly Journal of Economics, MIT Press, vol. 105(2), pages 285-319, May.
    9. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
    10. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
    11. Bester, Helmut, 1987. "The role of collateral in credit markets with imperfect information," European Economic Review, Elsevier, vol. 31(4), pages 887-899, June.
    12. Thorsten Beck & Asli Demirguc-Kunt & Ross Levine, 2003. "Bank Concentration and Crises," NBER Working Papers 9921, National Bureau of Economic Research, Inc.
    13. Philipp Hartmann & Elena Carletti, 2002. "Competition and Stability: What's Special about Banking?," FMG Special Papers sp140, Financial Markets Group.
    14. Etienne Wasmer & Philippe Weil, 2004. "The Macroeconomics of Labor and Credit Market Imperfections," American Economic Review, American Economic Association, vol. 94(4), pages 944-963, September.
    15. Franklin Allen & Douglas Gale, 2004. "Competition and financial stability," Proceedings, Federal Reserve Bank of Cleveland, pages 453-486.
    16. Broecker, Thorsten, 1990. "Credit-Worthiness Tests and Interbank Competition," Econometrica, Econometric Society, vol. 58(2), pages 429-52, March.
    17. Kanniainen, Vesa & Leppämäki, Mikko, 2002. "Financial institutions and the allocation of talent," Research Discussion Papers 5/2002, Bank of Finland.
    18. 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.
    19. Klaus Kultti & Juha Virrankoski, 2004. "Option to wait in a search model," Spanish Economic Review, Springer, vol. 6(2), pages 153-158, 07.
    20. David de Meza, 2002. "Overlending?," Economic Journal, Royal Economic Society, vol. 112(477), pages F17-F31, February.
    21. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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