Competition and Lending Standards with Multidimensional Private Information

Abstract

We investigate how loan terms respond to competition between lenders when borrowers have multidimensional private information. In our model, competitive lenders screen borrowers using contracts that consist of an interest rate and a collateral requirement. Compared to a monopolistic lender, a competitive market offers uniformly lower collateral requirements, and a larger share of funded projects are negative-NPV. The competitive market may be more or less efficient than the monopolist, depending on the deadweight cost of collateral and the degree of selection externalities. In principle, efficiency could be greatly improved by an uninformed regulator who completely controls the interest rate schedule. However, simpler policies such as minimum collateral or higher interest rates do little to improve efficiency.