Inefficiently Low Screening with Walrasian Markets

Abstract

Financial intermediaries devote resources to finding and screening borrowers before lending capital. By retaining only sufficiently good matches, informed lenders exacerbate adverse selection problems for others lending in the same market. Failure to internalize this implies that informed lenders are too selective in the matches they retain. The resulting under-use of capital pushes the cost of capital down, decreasing the benefit of being informed rather than uninformed and prompting a reallocation of resources from screening to matching. Compared to the constrained efficient allocation, the decentralized equilibrium has too little screening, too little informed credit, and too much uninformed credit.