Insider rates versus outsider rates in lending

Abstract

When information asymmetries exist between lenders, an uninformed outside bank that competes with an informed inside bank faces a winner’s curse. This paper examines a benchmark model’s prediction for interest rates. Although the outside bank wins more bad firms, the inside bank extracts rents from good firms and the outside bank underbids for bad firms. An analytical solution reveals the surprising result that the average interest rate paid to the inside bank following bidding outcomes can be higher than the average interest rate paid to the outside bank.