Credit allocation in heterogeneous banking systems

Abstract

Abstract World banking systems are almost invariably populated by relatively diverse financial institutions. This paper studies the operation of credit markets where heterogeneous banks compete for investment projects of varying quality in the presence of informational asymmetries. We emphasize on two dimensions of heterogeneity – access to project-specific information vis-à-vis funding costs – which naturally reflect lenders’ comparative disadvantages in the competitive landscape. Two main findings stand out. First, competition across heterogeneous banks can produce multiple equilibria. Thus, economies with similar fundamentals may well display a variety of interest rates and/or market shares for the operating institutions. Second, market failures (overlending) always prove mitigated in heterogeneous banking systems, relative to a world with equally uninformed lenders. This discipline effect however comes with a chance for market fragility, whereby modest changes in the business environment or other fundamentals can trigger large shifts in the price of credit, leading to either highly selective markets or rather ones which overfund ventures of the lowest quality. Extensions of the basic model and some policy implications are also discussed.