Working Paper: CEPR ID: DP1918
Authors: Michael Manove; A. Jorge Padilla
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 possible optimistic entrepreneurs. We examine this capital market from the stand-point 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 the 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 bank regulation and bankruptcy rules in connection with the problems that unrealistic entrepreneurs may present.
Keywords: banks; bankruptcy law; collateral; entrepreneurs; optimism
JEL Codes: G20; D81
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| competition among banks (G21) | insufficient conservatism in lending practices (G21) |
| insufficient conservatism in lending practices (G21) | reduced economic efficiency (D61) |
| screening problem (C24) | insufficient conservatism in lending practices (G21) |
| optimistic entrepreneurs (L26) | overestimate potential success of projects (O22) |
| overestimate potential success of projects (O22) | request loans that may not be justified (H81) |
| collateral requirements (G32) | encourage overconfidence among entrepreneurs (L26) |
| bankruptcy regulations (K35) | incentivize risky behavior among entrepreneurs (L26) |
| dynamics of the banking market (G21) | suboptimal investment decisions (G11) |
| suboptimal investment decisions (G11) | social costs (J32) |