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
Abstract
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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