Bank Competition and Loan Quality

We analyze the impact of bank competition on the equilibrium quality of loans in a formal model where banks do not observe the type of loan applicants, i.e. face an adverse selection problem, nor borrowers’ effort, i.e. also face a moral hazard problem. The main finding is that there exists an inverted U-shaped relationship between competition and the average quality of loans. Policy implications are derived from this result and from an extension to the basic model where banks may sequentially acquire information about potential borrowers.