Competitive Lending with Partial Knowledge of Loan Repayment (WP-08-11)


IPR-WP-08-11

William A. Brock and Charles F. Manski

We study a competitive credit market in which lenders, having partial knowledge of loan repayment, use a Bayesian, maximin, or minimax-regret criterion to make lending decisions. Lenders allocate endowments between loans and a safe investment, while borrowers demand loans to undertake investments. Borrowers may incompletely repay their loans when investment productivity turns out to be low ex post. We characterize market equilibrium, the contracted repayment rate being the price variable that equilibrates loan supply and demand. We explore market dynamics when a credit market that is initially in steady state experiences an unanticipated shock that temporarily lowers the productivity of borrower investments. The shock reduces loan repayment and lenders, not knowing whether the shock is temporary, then reduce loan supply. We study two forms of government intervention to restore the steady state. One policy manipulates the return on the safe investment and the other guarantee a minimum loan return to lenders. We conclude that the minimum-return guarantee is preferable. This policy directly reduces lender ambiguity in a transparent manner.

Charles F. Manski, Professor of Economics, Northwestern University
William A. Brock, Professor of Economics, University of Wisconsin

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