Asymmetric Information and the Market Structure of the Banking IndustryWP/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. |