Selling Dreams: Endogenous Optimism in Lending Markets

29 Pages Posted: 14 May 2020

See all articles by Luc Bridet

Luc Bridet

affiliation not provided to SSRN

Peter Schwardmann

Ludwig Maximilian University of Munich (LMU)

Date Written: 2020

Abstract

We propose a simple model of borrower optimism in competitive lending markets with asymmetric information. Borrowers in our model engage in self-deception to arrive at a belief that optimally trades off the anticipatory utility benefits and material costs of optimism. Lenders' contract design shapes these benefits and costs. The model yields three key results. First, the borrower's motivated cognition increases her material welfare, regardless of whether or not she ends up being optimistic in equilibrium. Our model thus helps explain why wishful thinking is not driven out of markets. Second, in line with empirical evidence, a low cost of lending and a booming economy lead to optimism and the widespread collateralization of loans. Third, equilibrium collateral requirements may be inefficiently high.

Keywords: optimal expectations, motivated cognition, wishful thinking, financial crisis, lending markets, screening

JEL Classification: D860, D820, G330

Suggested Citation

Bridet, Luc and Schwardmann, Peter, Selling Dreams: Endogenous Optimism in Lending Markets (2020). CESifo Working Paper No. 8271, Available at SSRN: https://ssrn.com/abstract=3598756

Luc Bridet (Contact Author)

affiliation not provided to SSRN

Peter Schwardmann

Ludwig Maximilian University of Munich (LMU) ( email )

Geschwister-Scholl-Platz 1
Munich, DE Bavaria 80539
Germany

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