Asymmetric Information and the Market Structure of the Banking Industry


WP/98/92-EA
WP/98/92


Summary

A large literature has identified asymmetric information as the defining
characteristic of credit markets. Lenders offering credit to borrowers face
uncertainty about their creditworthiness to the extent that they cannot observe
some of the borrowers' characteristics and actions. These informational
asymmetries cause adverse selection and moral hazard problems and may
invalidate standard competitive market results. However, over time, lenders
resolve part of these informational problems. In the process of lending,
financial intermediaries are able to gather some proprietary information about
borrowers. creditworthiness. Hence, they acquire some degree of informational
monopoly about their clients and thus market power. Unable to signal their
quality to competing lenders, creditworthy borrowers are locked in a
bank-client relationship and are forced to pay interest rates above the
competitive level.


The paper examines the role of asymmetric information in the determination of
the equilibrium structure of loan markets in the context of a multi-period
model of spatial competition. In particular, it endogenizes banks' entry and
exit decisions and investigates whether informational asymmetries in the
banking industry can create a barrier to entry for new lending institutions.
Learning by lending provides incumbent banks with an informational advantage
that may become an important determinant of the industry structure. Hence,
potential entrants may face adverse selection problems more severe than those
faced by incumbents for their lesser ability to discriminate among borrowers.
In this context, the paper shows that asymmetric information generates an
adverse selection effect that acts as a barrier to entry, preventing new
lenders from entering the market. Moreover, this incumbent advantage is larger
in markets where asymmetric information is more important. Technically, the
paper shows that, even in the absence of fixed costs, the market sustains only
a limited number of banks in equilibrium. This represents a new and
non-standard result for the literature on product differentiation.