How Public Information Affects Asymmetrically Informed Lenders: Evidence from a Credit Registry Reform

Abstract

We exploit exogenous variation in the amount of public information available to banks about a firm to empirically evaluate the importance of adverse selection in the credit market. A 2006 reform introduced by the State Bank of Pakistan (SBP) reduced the amount of public information available to Pakistani banks about a firm’s creditworthiness. Prior to 2006, the SBP published credit information not only about the firm in question but also (aggregate) credit information about the firm's group (where the group was defined as the set of all firms that shared one or more director with the firm in question). After the reform, the SBP stopped providing the aggregate group-level information. We propose a model with differentially informed banks and adverse selection, which generates predictions on how this reform is expected to affect a bank’s willingness to lend. The model predicts that adverse selection leads less informed banks to reduce lending compared to more informed banks. We construct a measure for the amount of information each lender has about a firm's group using the set of firm-bank lending pairs prior to the reform. We empirically show those banks with private information about a firm lent relatively more to that firm than other, less-informed banks following the reform. Remarkably, this reduction in lending by less informed banks is true even for banks that had a pre-existing relationship with the firm, suggesting that the strength of prior relationships does not eliminate the problem of imperfect information.

Keywords: adverse selection, credit markets, networks

JEL Classification: G14, O16