Bank Competition, Information Choice and Inefficient Lending Booms

5 Discussion and Implications
5.1 Predictions and Empirical Findings
With the central results in place, it is now time to take a step back and check how the
model’s properties and predictions relate to the existing empirical literature.
For a given level of competition, the model predicts the existence of procyclical lending
which is driven by variations in bank screening. Although bank screening effort is not
directly observable, there is empirical evidence in support of a lending cycle: Berger and
Udell (2004) find that credit growth following a favorable change in economic conditions
is more pronounced when a substantial amount of time has passed since the last wave
of defaulted loans. They explain this observation with what they call the “institutional
memory hypothesis”: in good times, so their argument, loan officers become increasingly
inefficient in recognizing bad credit risks until they experience a bust that allows them to
“re-learn” their abilities. Whilst they argue that this deterioration of screening standards
is an unintended consequence of problems of the organization like high staff turnover, my
model offers the perspective that a rational bank may actually find it optimal to let its
screening skills deteriorate in good times when there is a threat of outside competition.
If banks’ adjustments of screening precision λ are not instantaneous, for instance due to
adjustment cost, this deterioration will be gradual and therefore observationally equivalent
to the findings of Berger and Udell.
Equally in line with the screening cycle of my model are the findings of Ioannidou
et al. (2009) and Jiménez et al. (2009): these two studies employ micro-level loan data for
Bolivia and Spain, respectively, to investigate the impact of exogenous changes in monetary
policy rates on the quality of new and existing loans. Consistent with the model’s
prediction that for lower values of ρ (and thus q) banks screen their loan applications less
precisely and extend their lending towards inefficient projects, they observe that loans
that were made in times of low monetary policy rates are substantially more prone to
default.
The question whether adverse selection problems that are induced by incumbent
lenders matter for the entry decisions of banks has been addressed empirically by Gobbi
and Lotti (2004). They show in an analysis of the Italian retail loan market that higher
potential earning opportunities as measured by spreads between loan and deposit rates
do not attract competition from outside banks whereas earning opportunities in financial
services that do not require private information do attract entry. Likewise, Bofondi and
Gobbi (2006) observe that entrants in local Italian loan markets suffer from substantially
higher default rates than incumbent banks, even more so if they do not have a local branch
office. These findings corroborate the validity of my model’s central assumption that entry
in local credit markets is deterred by the inferior quality of outsiders’ information relative
to the incumbent lender.
But does available empirical evidence also support the model’s message with respect to
the effects of competition on asset selection and lending procyclicality? Before I answer
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