Competition in Loan Contracts

Abstract

We develop a simple model of competition in a loan market with no asymmetric information. Lenders compete by offering loan contracts which are a loan amount and an interest rate. A borrower may take up more than one contract and has an incentive to default which is increasing in the amount that she has borrowed. We show that if the incentive to default is high enough then firms in competition earn a positive profit and may even charge the monopoly price. In the latter case, the aggregate quantity in the market is equal to the amount a monopolist would provide. Further, there is a level of incentive to default above which no zero profit equilibria can be sustained. The positive profit equilibria are robust to increases in the number of lenders in the market. We argue that this model is appropriate for markets in which transactions are on credit rather than cash and in particular explains some of the stylized facts of the credit--card market. Our model implies that, given a choice of bankruptcy laws, consumers prefer strict bankruptcy laws and banks prefer lenient ones.

JEL Classification: D4, D11, G2