Lending to Uncreditworthy Borrowers

This paper models entry and competition in "high-risk" credit markets. It focuses on the lowest end of small businesses, and highlights the difficulties banks face in financing loans because of high agency costs in such markets. The paper states that an incumbent lenders advantage over any outside bank derives from the lenders knowledge its creditworthy clients and the uncreditworthy types in the borrower population. Findings indicate that:

• Screening is costly and the uninformed lenders ability to use collateral as a screening mechanism depends on its cost advantage over its informed rival;
• Outside bank can pool un-creditworthy borrowers with creditworthy types, but only if it has a low cost of funds;
• Secular decline in cost of funds does not help outside banks to screen un-creditworthy borrowers, but it allows them to pool these borrowers with creditworthy types.

Finally, the paper states that this framework is relevant for explaining the recent entry of outside banks into the sub prime-end of the loan market, for example, loans to the lowest end of small businesses in developing countries.