DP1725 Can Competition in the Credit Market be Excessive?

Author(s): Ramon Caminal, Carmen Matutes
Publication Date: October 1997
Keyword(s): Credit Rationing, market power, Monitoring, Moral Hazard
JEL(s): D82, G21, L10
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1725

We study the welfare implications of market power in a model where banks choose between credit rationing and monitoring in order to alleviate an underlying moral-hazard problem. We show that the effect of banks? market power on social welfare is the result of two countervailing effects. On the one hand, higher market power increases lending rates, worsens the borrower?s incentive problem and investment is further reduced below the efficient level. On the other hand, higher market power induces banks to exert higher monitoring effort and reduces the frequency of credit rationing. Whenever the second effect dominates, it is socially optimal to provide banks with some degree of market power.