Bank of Lithuania
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2020-02-18

Banking regulation and collateral screening in a model of information asymmetry

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This paper explores the impact of banking regulation on a competitive credit market with ex-ante asymmetric information and aggregate uncertainty. I construct a model where the government to impose a regulatory constraint that limits the losses banks make in the event of their default. I show that the addition of banking regulation results in three deviations from the standard theory. First, collateral is demanded of both high and low risk firms, even in the absence of asymmetric information. Second, if banking regulation is sufficiently strict, there may not exist an adverse selection problem. Third, a pooling Nash equilibrium can exist.

JEL Codes: D86, G21, G28.

The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.

Banking, Adverse Selection, Collateral, Banking regulation