Asymmetric Information and Imperfect Competition in Lending Markets

Abstract

We measure the consequences of asymmetric information and imperfect competition in the Italian market for small business lines of credit. We provide evidence that a bank’s optimal price response to an increase in adverse selection varies depending on the degree of competition in its local market. More adverse selection causes prices to increase in competitive markets, but can have the opposite effect in more concentrated ones, where banks trade off higher markups and the desire to attract safer borrowers. This implies both that imperfect competition can moderate the welfare losses from an increase in adverse selection, and that an increase in adverse selection can moderate the welfare losses from market power. Exploiting detailed data on a representative sample of Italian firms, the population of medium and large Italian banks, individual lines of credit between them, and subsequent defaults, we estimate models of demand for credit, loan pricing, loan use, and firm default to measure the extent and consequences of asymmetric information in this market. While our data include a measure of observable credit risk available to a bank during the application process, we allow firms to have private information about the underlying riskiness of their project. This riskiness influences banks’ pricing of loans as higher interest rates attract a riskier pool of borrowers, increasing aggregate default probabilities. We find evidence of adverse selection in the data, and increase it with a policy experiment to evaluate its importance. As predicted, in the counterfactual equilibrium prices rise in more competitive markets and decline in more concentrated ones, where we also observe an increase in access to credit and a reduction in default rates. Thus market power may serve as a shield against the negative effects of an increase in adverse selection.