Loan Screening under Symmetrically Imperfect Information

Abstract

We propose a canonical model of loan screening under symmetrically imperfect information. The project quality is unknown to both a lender and a borrower, but it is revealed with noise to the lender with cost. We show that, under meaningful parameter values, there are three types of equilibria: (i) screening and separating equilibrium, (ii) non-screening and pooling equilibrium, and (iii) non-screening and cheap-information-based separating equilibrium. They are all constrained socially optimal. In particular, the screening and separating equilibrium emerges when the average project quality is low or when the interest rate is high.