Ex-ante Asymmetric Information in Credit Markets and Macroeconomic Fluctuations

Title of dissertation: EX-ANTE ASYMMETRIC INFORMATION IN CREDIT MARKETS AND MACROECONOMIC FLUCTUATIONS Hatice Elif Ture, Doctor of Philosophy, 2013 Dissertation directed by: Professor Anton Korinek Department of Economics This dissertation analyzes macroeconomic effects of ex-ante information acquisition problems between lenders and borrowers in credit markets. It examines the ways in which the costs associated with the screening of privately informed heterogeneous loan applicants affect contractual arrangements, efficient allocation of credit and macroeconomic fluctuations. Screening costs can take on two different forms: i) the direct costs incurred by borrowers through collateral requirements and credit limits, ii) the resource costs incurred by lenders for spending time, effort and money on screening loan applicants, which are passed on to borrowers through higher loan rates. This dissertation is organized into two parts, analyzing macroeconomic implications of these two types of screening costs. In the first chapter, entitled “Collateralization, Credit Allocation and Investment Dynamics”, we focus on the case where screening can be achieved by collateral requirements and credit limits. We analyze how changes in collateral availability affect aggregate investment and output dynamics through the misallocation of bank credit across heterogeneous investors. We develop a theoretical model of the credit market where banks cannot fully assess the credit risk of investors, and collateral capacity of investors becomes crucial in the design of financial contracts that facilitate efficient allocation of credit. In the proposed framework, there are observable and unobservable components to a borrower/investor’s credit risk. Banks are able to group borrowers into risk classes based on their observable characteristics such as their collateral capacity. However, within a quality group there are still higher and lower risk borrowers that cannot be observationally distinguished. For any group of borrowers with common observable quality, banks may design either pooling or separating contracts. Pooling contracts offer efficient loan amounts but entail cross subsidization of high risk borrowers, while separating contracts offer efficient loan rates but entail credit rationing of low risk borrowers. We show that a financial shock that reduces the collateral capacity of borrowers may switch the financial contracts designed for low quality borrowers from pooling to separating, which increases credit rationing within low quality group and reallocates credit in favor of high quality borrowers. Thus, our framework generates a flight to quality in bank lending, which is documented in the empirical literature to precede the recessions and predict future reductions in real GDP. This flight to quality occurs in our framework because banks tighten credit standards, or the terms of financial contracts, more for relatively risky or low quality borrowers when financial conditions worsen. The differential access to credit across these investors decreases aggregate investment efficiency and real economic activity. In the second chapter, entitled “Costly Screening in Credit Markets, Net Worth Effects and Business Cycles”, we focus on the case where screening can be achieved by incurring resource costs. We build a dynamic general equilibrium model featuring costly screening of loan applicants to examine how aggregate shocks are amplified and propagated through net worth effects compared to a standard model of ex-post monitoring costs, which has become the work-horse framework to analyze macrofinancial linkages. In the model, loan applicants tend to hide the prospects of their projects absent screening, and lenders have access to a costly screening technology to evaluate the creditworthiness of loan applicants, which is a way to economize on the agency costs induced by pooling all borrowers, but is an agency cost in and of itself, making loan terms, and in turn investment, dependent on borrower net worth. Borrower screening is inversely proportional to borrower net worth: as the borrower’s stake in investment rises the need for screening falls. When borrower net worth is low, borrowers are subject to higher screening; and since screening costs are passed on to borrowers through higher loan rates, lower net worth increases the cost and decreases the availability of external funding. When there is an adverse aggregate productivity shock, borrower income or net worth falls and external finance becomes more expensive. As a result, both internal and external sources of finance shrink, decreasing aggregate investment and output, and further decreasing borrower net worth. In this way aggregate shocks are propagated through their effects on borrower net worth. Thus, we show that the costly screening framework can be an alternative to widely assumed monitoring costs in generating net worth effects that enhance the propagation of aggregate shocks. One advantage of the screening framework is that it yields wealth effects that induce persistent dynamics especially in bad times when borrower screening is more likely, which may create longer and deeper busts than booms. In addition to that, by yielding efficient risk pricing and quantity rationing endogenously as in actual bank lending practices, the screening framework constitutes an empirically plausible alternative to monitoring costs to motivate the agency costs in unsecured lending. EX-ANTE ASYMMETRIC INFORMATION IN CREDIT MARKETS AND MACROECONOMIC FLUCTUATIONS