Asymmetric information, signalling and competition in the credit market

This paper examines how credit market structure affects signalling under asymmetric information between banks and firms. In particular, it is shown that competition can be inconsistent with separating equilibria and, in turn, with efficient pricing rules. Under low competition contract differentiation is important, and good firms credibly signal their quality by choosing informative financial contracting. However, as competitive pressures increase the value of information necessary to separate shrinks and financial contracts becomes uninformative about quality. Then, separating equilibria do not exist and banks fail to price loans according to quality of applicant firms. Moreover, when all projects are viable, full competiton imposes a trade-off between investment financing and price-efficiency. With nonviability such a trade-off desappears.