Working Paper: CEPR ID: DP8226
Authors: Alberto Martin
Abstract: We analyze a standard environment of adverse selection in credit markets. In our environment, entrepreneurs who are privately informed about the quality of their projects need to borrow in order to invest. Conventional wisdom says that, in this class of economies, the competitive equilibrium is typically inefficient.We show that this conventional wisdom rests on one implicit assumption: entrepreneurs can only access monitored lending. If a new set of markets is added to provide entrepreneurs with additional funds, efficiency can be attained in equilibrium. An important characteristic of these additional markets is that lending in them must be unmonitored, in the sense that it does not condition total borrowing or investment by entrepreneurs. This makes it possible to attain efficiency by pooling all entrepreneurs in the new markets while separating them in the markets for monitored loans.
Keywords: adverse selection; collateral; credit markets; monitored lending; screening
JEL Codes: D62; D82; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| introducing unmonitored lending (G21) | increase in efficiency (D61) |
| good entrepreneurs access better terms in monitored markets (M13) | reduction in incentive compatibility constraint (D10) |
| unmonitored lending (G21) | good entrepreneurs raise resources without conditioning investment (P12) |
| good entrepreneurs issue promises in unmonitored markets (D40) | access better terms in monitored markets (G10) |
| unmonitored lending (G21) | efficient outcomes (D61) |
| government intervention (O25) | market efficiency (G14) |