Working Paper: CEPR ID: DP4320
Authors: Sumru G. Altug; Murat Usman
Abstract: In this Paper, we examine bank lending decisions in an economy with spillover effects in the creation of new investment opportunities and asymmetric information in credit markets. We show that such features may lead to strategic considerations in the loan extension decision and in the pricing of loan contracts. We consider both lending and under-lending equilibria when the interest rate is exogenously given to banks. We show the existence of an asymmetric under-lending equilibrium in which productive investment projects do not get financed even if banks have adequate lending capacity. We also examine price-setting equilibria in which banks compete over interest rates charged to firms. We show that there exist price-setting equilibria in which all projects get financed if ex-post feasible. There also exists, however, an under-lending equilibrium in which when one bank does set a lower interest rate to capture a larger market, it may simultaneously reduce its lending. Our results suggest that volatility and unpredictability in bank lending capacities may be a key indicator of various adverse outcomes in our model
Keywords: bank lending; interest rate competition; self-fulfilling beliefs; spillover effects; underlending equilibria
JEL Codes: C72; G21; O16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| spillover effects and asymmetric information (D82) | strategic considerations in loan extension decisions (G21) |
| spillover effects and asymmetric information (D82) | asymmetric underlending equilibrium (D53) |
| asymmetric underlending equilibrium (D53) | productive investment projects fail to receive financing (G31) |
| bank lending decisions (G21) | influenced by strategic considerations (L21) |
| interest rate competition among banks (E43) | financing outcomes for projects (G32) |
| lower interest rates (E43) | increased financing (G32) |
| lower interest rates (E43) | reduced lending if banks strategically undercut each other (G21) |
| fluctuations in bank lending capacities (G21) | indicative of potential adverse outcomes in the economic model (E17) |