Lending to uncreditworthy borrowers

Abstract

We study optimal lending behavior under adverse selection in environments with heterogeneous borrowers-speci…cally, where the borrower's reservation payo¤s (outside options) increase with quality (creditworthiness). Our results show that factors a¤ecting credit supply can also a¤ect lending standards either directly through lending costs or indirectly through borrower reservation payo¤s. Lending to uncreditworthy borrowers can be prevented by lowering reservation payo¤s, by raising lending costs, or both. Lenders seeking to attract creditworthy borrowers with high reservation payo¤s would have to lower rates and, consequently, increase collateral requirements on o¤ers that screen out uncreditworthy types. This leads to higher screening costs, thereby increasing the pro…tability of o¤ers that pool uncreditworthy borrowers-a veritable lowering of credit standards. In addition, equilibria in a competition version of the model can also explain the phenomenon of "cream-skimming" by outside (foreign) lenders. Surprisingly, we …nd that the presence of an informed rival actually aids "cream-skimming" behavior.

Foreign Banks’ Entry and Local Banks’ Strategies in China

“…If a borrower succeeds in an investment, the borrower pays the principal and interest to the bank; if, on the other hand, a borrower fails, the bank liquidates the collateral, obtaining βC , where 0 < β < 1, and the value of β reflects a bank's collateral liquidation capability. According to Sengupta () and Haselmann et al . (), the value of β is associated with both the legal soundness and the bank's understanding of the market.…”

“…Sengupta (, ) argues that the host country's legal environment will affect foreign banks’ capabilities of selling the collateral. More specifically, provided that the host country affords better protection of creditors’ rights and tougher enforcement of the law, foreign banks’ capability of liquidating collateral in the country will be increasingly strong, thus, they will tend to choose greenfield investment as an entry mode.…”

“…() conclude that collateral can mitigate the adverse selection that is caused by information asymmetry between the customer and the bank. Sengupta (, ) states that to overcome their information disadvantages, foreign banks may use collateral, and he analyzes the factors that affect the entry of foreign banks on this basis. He then concludes that the stronger the foreign banks’ capabilities to liquidate collateral are, the more easily they enter a host country, with the entry mode of foreign banks being affected by their collateral liquidation capabilities.…”

“… The parameters of bank competition are cited from Sengupta (). Parameters such as the risk‐free interest rate, the drift rate, and the volatility rate of the credit market size are derived from Pindyck and Dixit () and Liu (). …”

To Basel or not to Basel? Banking crises and contagion

“…Payment systems and loan collaterals could be handled according to Kahn (2013). The decision on whether or not to lend to an agent, as well as the cost of lending, could be handled according to Sengupta (2014). Also, banks do not use leverage to increase their available funds.…”