Competition in Lending: Theory and Experiments*

Abstract

A variation of the Rothschild-Stiglitz' equilibrium is examined in the context of competitive lending under adverse selection. The predictions of the model are tested in an experimental market setting. If equilibrium exists, it predicts that the loan contracts offered and taken separate the projects being financed by quality. When equilibrium exists, the experiments confirm the theory.The entrepreneurs with high-risk projects take bigger loans and bear higher credit spreads than those with low-risk projects. When equilibrium does not exist, which happens exactly when the candidate for equilibrium does not provide a Pareto-optimal allocation, in half of the sessions loan trading stabilizes around the candidate equilibrium pair. In the other half, however, markets never settle down. This finding has important implications. When lenders can offer menus of contracts, as is usually the case in the real world, the outcome may not be the zero-profit separating contracts of the standard model in the theory of corporate finance. Worse, as an example in the paper illustrates, fitting the standard model to field data may lead to serious biases in estimated parameters while falsely accepting the model's main restriction (separation). * The financial support of the Division of Humanities and Social Sciences at Caltech is gratefully acknowledged. I would like to thank Charles Plott, Thomas Palfrey, Bill Zame, Mike Lemmon, as well as the seminar participants at Caltech, UCSD, Duke, Berkeley, Stanford, University of Utah, Columbia, Georgia State University, Tulane, University of Houston, and Arizona State University for helpful comments. I am especially grateful to Peter Bossaerts for all his suggestions and comments, and the staff of EEPS, SSEL, and CASSEL for their help in running the experiments. All errors are my own.

Securities Auctions under Moral Hazard: An Experimental Study*

“…Perhaps most closely related to our paper is Asparouhova (2006) who examines competition in a screening model. Along these same lines, Goswami, Grace, and Rebello (2008) study equilibrium contracting in a signaling model.…”

“…At various times, oil tracts have been auctioned using cash contracts with a …xed royalty component, pure royalty contracts, and even pure pro…t share contracts. 1 Likewise, in …nancing mergers and acquisitions, an acquiring …rm must determine both the right "bid" to gain approval from shareholders as well as the right form of the bid in terms of the health of the balance sheet of the merged company. Again, the contractual forms vary widely ranging from pure cash acquisitions, leveraged buyouts, to pure equity o¤ers.…”

Competition in Portfolio Management: Theory and Experiment

“…Second, in the field, there is plenty of casual support for its main predictions. 3 Third, these and other predictions have recently been confirmed in experimental testing (Asparouhova 2006). Berk and Green (2004) also consider competition between fund managers, but their model focuses on fee competition in the face of learnable talent differences.…”

Competitive Insurance Markets and Adverse Selection in the Lab

“…Third, by designing two successive experiments, we are able to assess the effectiveness of deductible 12 Posey and Yavas (2007). 13 Asparouhova (2006). 14 In the model of Rothschild and Stiglitz,2 all individuals are endowed with the same utility function.…”