A Dynamic Theory of Learning and Relationship Lending

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