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Interbank Competition with Costly Screening

Xavier Freixas: Department of Economics and Business, CREA and CEPR, Universitat Pompeu Fabra

Sjaak Hurkens: Department of Economics and Business and CREA, Universitat Pompeu Fabra

Alan D. Morrison: Saïd Business School and Merton College, University of Oxford, and CEPR

Nir Vulkan: Saïd Business School and Worcester College, University of Oxford



We analyse credit market equilibrium when banks screen loan applicants. When banks have a convex cost function of screening, a pure strategy equilibrium exists where banks optimally set interest rates at the same level as their competitors. This result complements Broecker’s (1990) analysis, where he demonstrates that no pure strategy equilibrium exists when banks have zero screening costs. In our set up we show that interest rate on loans are largely independent of marginal costs, a feature consistent with the extant empirical evidence. In equilibrium, banks make positive profits in our model in spite of the threat of entry by inactive banks. Moreover, an increase in the number of active banks increases credit risk and so does not improve credit market efficiency: this point has important regulatory implications. Finally, we extend our analysis to the case where banks have differing screening abilities.


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