Banks provision credit to borrowers with collateral of varying stability in the presence or absence of information sharing and with differing degrees of creditor rights protection. The authors evaluate how these factors affect bank lending.
Game theory is applied to show that the price of credit and its availability vary as a function of the volatility of borrowers’ collateral and the degree of creditor protection. Uncertainty of collateral value and a lack of robust creditor rights in the absence of information sharing about a borrower’s debt history may lead to defensive credit rationing, opportunistic lending, or a market freeze. Indeed, information sharing may exacerbate the potential for rationing or a market freeze. Cited empirical evidence supports the deductions made from the authors’ analysis of their stylized model.
How Is This Research Useful to Practitioners?
In markets where creditor protection rights are deficient, collateral values are unpredictable, information sharing between banks is infrequent or absent, and interest and default rates tend to be higher. Debtors with unstable collateral and limited liability tend to overextend themselves through multiple bank borrowings. Banks may decide to lend in an opportunistic fashion to individuals whose collateral is questionable or to ration credit to protect themselves. Credit-reporting systems help reduce excessive borrowing, which, in turn, causes interest and default rates to decline.
Lack of information sharing may produce three outcomes, depending on the degree of creditor protection. Where such rights are well protected, entrepreneurs can borrow at lower rates. At the other extreme of poorly protected rights and very unstable collateral values, credit rationing prevails at varying terms—some approaching usurious rates—or credit markets freeze entirely. In between, where intermediate levels of creditor protection exist, two possible scenarios occur. In one scenario, lenders may ration credit, borrowers with loans at multiple banks may strategically default, and lenders may avoid extension of credit to overextended entrepreneurs. In the other scenario, lenders extend credit at positive-profit rates, with one bank serving one borrower. Other banks avoid opportunistic lending to prevent a situation in which the entrepreneur engages in moral hazard, taking additional loans and defaulting.
In the presence of information sharing, the provision of credit is a function of borrowers’ credit history. Such knowledge mitigates opportunistic lending and promotes efficiency through credit availability, lower interest rates, and fewer instances of default given moderate creditor protection and stable collateral. A potential negative effect of information sharing may occur with borrowers whose collateral is quite volatile. Lenders may extend credit to low-debt borrowers hoping for collateral appreciation. Opportunistic lending, credit rationing, or a market freeze may result particularly when creditor protection is poor. This outcome may be experienced by developing countries or in turbulent markets that characterize a financial crisis.
Bank executives, regulators, and policymakers can all glean valuable information from the authors’ findings. Indeed, they are material for decisions on lending policy and the regulatory conditions affecting the economic growth of a country.
How Did the Authors Conduct This Research?
The authors develop a model using game theory to test three predictions. High-risk collateral and poorly protected creditor rights should lead to greater credit rationing and increased interest and default rates. Banks’ information sharing about clients’ previous debts should lead to reduced default and interest rates. The degree of information sharing should increase credit access when borrowers’ collateral is stable but reduce access when collateral is unstable and creditor protection is poor. Empirical evidence tends to support these suppositions.
The authors’ model assumes that an entrepreneur is risk neutral and may engage in either a large or small project; that the bank cannot verify the size of the project or whether the entrepreneur borrows from other banks; that limited liability protects the borrower, who derives personal benefit from the large but not the small project; that future wealth may vary and is difficult to verify; that bankruptcy claimants receive payment according to seniority; and that a large project would not be viable. Together, these assumptions generate large incentives for the entrepreneur to engage in moral hazard.
The authors evaluate the multiplicity of outcomes in which information sharing exists or is absent. Payoffs to the banks and the entrepreneur occur according to the degree of the information shared and credit terms offered.
The model is robust to banks’ sequential loan offers and changes in the relative bargaining power of banks and entrepreneurs. Information sharing among banks in which borrowers have robust collateral should result in greater efficiencies and better lending practices. In those instances in which borrowers’ collateral is volatile, such best practices tend not to prevail.
Testing and observing the ongoing validity of the authors’ derivations across a broader spectrum of global credit markets would be useful continuing research.