Interbank Competition with Costly Screening

Xavier Freixas, Sjaak Hurkens, Alan D. Morrison and Nir Vulkan

Abstract: We analyze credit market equilibrium when banks screen loan applicants. When banks have a convex cost function of screening, a pure strategy equilibrium exists where banks optimally set interest rates at the same level as their competitors. This result complements Broecker's (1990) analysis, where he demonstrates that no pure strategy equilibrium exists when banks have zero screening costs. In our set-up we show that interest rates on loans are largely independent of marginal costs, a feature consistent with the extant empirical evidence. In equilibrium, banks make positive profits in our model in spite of the threat of entry by inactive banks. Moreover, an increase in the number of active banks increases credit risk and so does not improve credit market efficiency: this point has important regulatory implications. Finally, we extend our analysis to the case where banks have differing screening abilities.

Keywords: Credit market, screening, banking, entry.

Classification Number: G21, L11 .

B.E. Journal of Theoretical Economics 7: Iss. 1 (Topics). Article 15. (2007)