Working Paper: CEPR ID: DP1725
Authors: Ramon Caminal; Carmen Matutes
Abstract: We study the welfare implications of market power in a model where banks choose between credit rationing and monitoring in order to alleviate an underlying moral-hazard problem. We show that the effect of banks? market power on social welfare is the result of two countervailing effects. On the one hand, higher market power increases lending rates, worsens the borrower?s incentive problem and investment is further reduced below the efficient level. On the other hand, higher market power induces banks to exert higher monitoring effort and reduces the frequency of credit rationing. Whenever the second effect dominates, it is socially optimal to provide banks with some degree of market power.
Keywords: market power; monitoring; credit rationing; moral hazard
JEL Codes: D82; G21; L10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased market power (D43) | Higher lending rates (G21) |
| Higher lending rates (G21) | Negative impact on borrowers' incentives (G21) |
| Negative impact on borrowers' incentives (G21) | Reduced investment levels (G31) |
| Increased market power (D43) | Greater monitoring efforts by banks (G21) |
| Greater monitoring efforts by banks (G21) | Decreased frequency of credit rationing (E51) |
| Decreased frequency of credit rationing (E51) | Enhanced investment levels (E22) |
| When monitoring efforts outweigh negative effects of higher lending rates (G21) | Total welfare can increase with market power (D69) |
| Negligible credit rationing (G21) | Social welfare decreases with increased market power (D69) |