Loan Rate Differences Across Financial Sectors: A Mechanism Design Approach

Abstract

This paper shows that discrete and vastly different loan rates offered by different types of financial firms constitute, in fact, an elaborate mechanism that makes borrowers tell the truth regarding their ability to pay back loan principal and interest. Suppose that once a borrower fails to pay back a loan to a bank, he cannot borrow from any banks again and must contact higher-interest charging credit finance companies to get a new loan. This creates a well-defined incentive for borrowers: pay back and remain in the banks' loan market vs. do not pay back and move to, say, credit finance companies' loan market in which a higher loan rate is charged. This mechanism does not require the financial firms to verify even if the borrower declares bankruptcy, and therefore is more efficient than a standard debt contract A la Townsend (1979) in terms of verification cost. As the interest rates offered by different types of financial firms should be well aligned in order to prevent the deception of borrowers, we can also analyze how many different types of financial firms, that is, how many discrete and different loan rates, can co-exist in the economy.