Banking (Conservatively) with Optimists

CEMFI Working Paper 9718

Posted: 31 Jan 1998

See all articles by Michael Manove

Michael Manove

Boston University - Department of Economics

Jorge Padilla

Compass Lexecon

Multiple version iconThere are 2 versions of this paper

Date Written: December 1997

Abstract

In the course of ordinary business, commercial banks frequently encounter entrepreneurs seeking loans for the purpose of financing new or continuing projects. These entrepreneurs are frequently unrealistic, their perception having been biased by wishful thinking. Bankers are left with a difficult screening problem: separating realists from optimists who may be clever and knowledgeable and completely sincere in their optimistic beliefs. In this paper we model and explore the relationship between banks and possibly optimistic entrepreneurs. We examine this capital market from the standpoint of economic efficiency. We show that entrepreneurs may practice self-restraint in their current borrowing in order to signal realism and thus obtain good rates on future loans. But contrary to conventional wisdom, competition may lead banks to be insufficiently conservative in their dealings with entrepreneurs, despite entrepreneurial self-restraint. Furthermore, we argue that the use of collateral requirements by banks may lead to a further decrease in the level of economic efficiency attained. We discuss policies for dealing with the problems that unrealistic entrepreneurs may present to the banking industry.

JEL Classification: D80, G21

Suggested Citation

Manove, Michael and Padilla, Jorge, Banking (Conservatively) with Optimists (December 1997). CEMFI Working Paper 9718. Available at SSRN: https://ssrn.com/abstract=56237

Michael Manove

Boston University - Department of Economics ( email )

270 Bay State Road
Boston, MA 02215
United States
617-353-3299 (Phone)
617-353-4449 (Fax)

Jorge Padilla (Contact Author)

Compass Lexecon ( email )

Paseo de la Castellana 7
Madrid, 28046
Spain

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