Loan Screening When Banks Have Superior Information Technology

Abstract

We analyze the loan market under symmetrically imperfect information: the project quality is unknown to both a bank and a firm, but it is revealed with noise to the bank with cost. We show that there are three equilibria, that is, (i) a screening and separating equilibrium, (ii) a non-screening and pooling equilibrium, and (iii) a non-screening, cheap-information based separating equilibrium. They emerge depending on parameter values and are all socially optimal. In particular, the screening and separating equilibrium emerges when the average project quality is low, or when the international interest rate is high. Policies, such as credit easing, business subsidy, and public loan guarantees, make banks reduce or even stop screening. Then, more capital is allocated to unviable firms, resulting in a smaller national income and lower social welfare.