Bank Competition, Information Choice and Inefficient Lending Booms

1 Introduction
Over the past two decades, many countries worldwide have undertaken a process of deregulation
1 of their financial sectors that has turned tightly regulated oligopolistic banking
landscapes into much more competitive industries. It is widely believed that these reforms
have provided credit-constrained firms and self-employed workers with better access to
bank credit. However, the increasing occurrence of credit-driven boom-bust cycles 2 raises
the question whether this increase in competition may have come at a cost: anecdotal
evidence suggests that in episodes of strong economic outlook, credit may actually have
become too easy to obtain. In good times, so the narrative goes, competitive pressure
drives banks to reduce their screening effort and lower their lending standards, resulting
in the build-up of large positions of poorly screened assets in their balance sheets that lay
the foundations for the next financial crisis.
In this paper, I develop a theory of inefficient lending cycles that are driven by banking
competition. In a model of borrower screening, I obtain two main results: first, more
competition can incentivate informed incumbent banks to knowingly take bad projects
into their loan portfolio. This is optimal because it protects them against the entry of
uninformed lenders who could poach their customers. Instead of raising welfare by reducing
markups, more bank competition exerts detrimental downward pressure on lending
standards. Since in equilibrium banks offer credit to some borrowers despite of a negative
screening evaluation, they also fail to make best use of their information which leads to
my second main result: if banks choose their screening precision endogenously, I find that
competition reduces borrower screening to inefficiently low levels. The combination of
these two results provides me with a powerful theory of the credit cycle.
The key to my findings is to acknowledge that just like all other information centric
industries, banks may face difficulties in protecting their private information when assessing
credit. Specifically, I assume in my model that the lending decisions of privately
informed banks can be observed by uninformed competitors. This could for example be
the case if banks are legally required to present their loan offers in writing. Loan-approved
borrowers could then use the written offer to credibly signal their positive evaluation to
an uninformed outside lender in the attempt to receive a better offer.
When actions are observable by competitors, an informed incumbent bank must strike
a careful balance between optimizing her portfolio quality and protecting herself from
competition: the more wisely she chooses her loan portfolio, the more positive information
will be conveyed by every loan approval, and the more profitable it becomes for uninformed
outside lenders to enter the incumbent’s market and poach loan-approved customers. If
the informed incumbent “poisons the well” by making less prudent choices for her own
1 e.g. in the U.S. the 1994 Riegle-Neal Act eliminated previous interstate banking and branching
restrictions, and the 1999 Gramm-Leach-Bliley Act repealed the separation between investment and
commercial banking. For information on banking liberalization across countries, see Abiad et al. (2010).
2 For stylized facts and more discussion of credit-driven boom-bust cycles, see Borio and Lowe (2002),
Tornell and Westermann (2002), Eichengreen and Mitchener (2003), Mendoza and Terrones (2008, 2012),
Hume and Sentance (2009) and Schularick and Taylor (2009).
2