Interbank Competition with Costly Screening
Universitat Pompeu Fabra; Centre for Economic Policy Research (CEPR)
Institute for Economic Analysis
Alan D. Morrison
University of Oxford - Said Business School; University of Oxford - Merton College
University of Oxford - Said Business School
Oxford Financial Research Centre Working Paper No. 2005-FE-02
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.
Number of Pages in PDF File: 25
Keywords: Credit market, screening, banking, entry
JEL Classification: G21, L11working papers series
Date posted: January 25, 2005
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