DP1918 | Banking (Conservatively) With Optimists

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In the course of ordinary business, commercial banks frequently encounter entrepreneurs seeking loans for the purpose of financing new or continuing projects. These entrepreneurs are frequently unrealistic, their perception having been biased by wishful thinking. Bankers are left with a difficult screening problem: separating realists from optimists who may be clever and knowledgeable and completely sincere in their optimistic beliefs. In this paper we model and explore the relationship between banks and possible optimistic entrepreneurs. We examine this capital market from the stand-point of economic efficiency. We show that entrepreneurs may practice self-restraint in their current borrowing in order to signal realism and thus obtain good rates on future loans. But contrary to the conventional wisdom, competition may lead banks to be insufficiently conservative in their dealings with entrepreneurs, despite entrepreneurial self-restraint. Furthermore, we argue that the use of collateral requirements by banks may lead to a further decrease in the level of economic efficiency attained. We discuss bank regulation and bankruptcy rules in connection with the problems that unrealistic entrepreneurs may present.