Lending Competition and Funding Collaboration

Abstract

We study competition and collaboration between a bank and a shadow bank that lend in the same market plagued by adverse selection. The bank has cheaper funding, whereas the shadow bank is endowed with a better screening technology. Our innovation is to allow the bank to lend to the shadow bank, i.e., to finance its competitors. This interbank arrangement lowers shadow bank’s funding cost and reduces the bank’s incentive to compete. We show two lenders collaborate when the average quality of the borrower pool is low but compete when the quality gets high. While the shadow bank always benefits from interbank financing, the bank receives more profits only when the average quality is high, at the expense of higher interest rates faced by the borrowers.

Keywords: shadow bank, lending competition, interbank funding, winner’s curse, financial inclusion

JEL Classification: G21, G23