A Dynamic Theory of Learning and Relationship Lending

62 Pages Posted: 2 May 2019 Last revised: 17 Mar 2020

See all articles by Yunzhi Hu

Yunzhi Hu

University of North Carolina (UNC) at Chapel Hill - Finance Area

Felipe Varas

Duke University - Fuqua School of Business - Finance Department

Date Written: March 16, 2020

Abstract

We introduce private learning into a banking model to study the dynamics of relationship lending. In our model, an entrepreneur chooses between bank and market financing. Bank lending facilitates learning over time, but it subjects the borrower to the downside of an information monopoly. We construct an equilibrium in which the entrepreneur starts with bank financing and subsequently refinances with the market, and we find conditions under which this equilibrium is unique. Our model generates several novel results. First, both information asymmetry and the entrepreneur's reputation are accumulated over time. As a result, the bank will roll over bad loans for entrepreneurs who have accumulated enough reputation for the prospect of future loan sales. Second, this incentive to extend and pretend gets mitigated when the entrepreneur faces financial constraints. We further endogenize learning as the bank's costly decision and show how asymmetric information and financial constraints affect it.

Keywords: private learning, experimentation, reputation, relationship banking, information monopoly, debt rollover, extend and pretend, adverse selection, dynamic games

JEL Classification: G21, D82, D83, C73

Suggested Citation

Hu, Yunzhi and Varas, Felipe, A Dynamic Theory of Learning and Relationship Lending (March 16, 2020). Available at SSRN: https://ssrn.com/abstract= or http://dx.doi.org/10.2139/ssrn.3363685

Yunzhi Hu (Contact Author)

University of North Carolina (UNC) at Chapel Hill - Finance Area ( email )

Kenan-Flagler Business School
Chapel Hill, NC 27599-3490
United States

Felipe Varas

Duke University - Fuqua School of Business - Finance Department ( email )

Durham, NC 27708-0120
United States

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