Strategic Experimentation in Financial Intermediation with Threat of Entry

Abstract

We study how financial intermediation affects real market variables when an incumbent firm is threatened by entry to its market and must contract with a bank for outside funds. Contracts between the bank and the monopolist are short-term and redesigned after the entry decision of a second firm has been made. We show that---as is often the case in short term contracting without commitment---the first period contract contains signal dampening and experimentation effects. More importantly, however, we show that the threat of entry substantially impacts the significance of both effects. Thus, potential entry reduces the impact of signal dampening. And experimentation takes on a strategic aspect, since it must account for the the potential game between incumbent and entrant should entry occur. As a consequence of this, the first period contract is structured to reduce the probability of entry.

JEL Classification: C73, D8, L1