DP1295 | Endogenous Communication Among Lenders and Entrepreneurial Incentives

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When banks have an informational monopoly about their borrowers, the latter incentives can be thwarted by the fear that the return on their effort will be partly appropriated by their banks via high future interest rates. Banks can correct this incentive problem through a commitment to share with other lenders their private information about the quality of their customers. The resulting competitive pressure forces them to forgo opportunistic behaviour in the future and encourages borrowers to perform better. As a result, information sharing among banks has two opposite effects on their profits: the borrowers' higher effort levels raise current profits (while each bank retains an informational advantage), but the fiercer competition triggered by information sharing lowers future profits. The trade-off between these two effects determines the banks' choice to sign an information-sharing agreement. Their decision affects the degree of banking competition, the level and time profile of interest rates charged to clientele and the volume of lending, as well as the welfare of borrowers.