Entry deterrence in banking: the role of cost asymmetry and adverse selection

Mallick, Indrajit (2011): Entry deterrence in banking: the role of cost asymmetry and adverse selection. Forthcoming in: : pp. 1-18.

Abstract

Abstract

In this paper, we review and explore the strategic mechanisms that deter entry in banking. The literature relies on externality between banks to generate entry deterrence. Typically, the externality generated is caused by differential adverse selection faced by incumbents and entrants. In this paper it is shown that adverse selection problem between a bank and its borrowers is neither a necessary nor a sufficient condition for entry deterrence. We show that cost asymmetry between different types of incumbents and private information about costs can generate conditional entry deterrence. This source of externality can cause entry deterrence just as other types of externalities created by differential adverse selection. Forward contracts can act as signaling device for incumbent costs. Incorporating adverse selection problem in the credit market in fact relaxes entry conditions: entry can take place even if the incumbent is of strong type and can signal credibly.

• Item Type: MPRA Paper
• Language: English
• Keywords: Key Words: Entry Deterrence, Cost Asymmetry, Adverse Selection, Signaling
• Subjects: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C70 - General; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

References

Aghion, P. And P. Bolton [1987], "Entry Prevention Through Contracts with Customers", American Economic Review 77: 388-401.

Berger, A., S. Bonime., L. Goldberg, L. White (1999) “The Dynamics of Market Entry : The Effects of Mergers and Acquisitions on De Novo Entry and Small Business Lending in the Banking Industry” Working paper, Board of Governors of the Federal Reserve System.

Berger, A., G. Hanweck and D. Humphrey [1987] “Competitive Viability in Banking: Scale, Scope and Product Mix Economies”, Journal of Monetary Economics, 20, 501-520

Berger, A., and D. Humphrey [1991] “The Dominance of Inefficiencies over Scale and Product Mix Economies in Banking”, Journal of Monetary Economics, 28, 117-148

Berger, A., and L. Mester [1997] “Inside the Black Box: what explains the Differences in the Efficiencies of the Financial Institutions”, Journal of Banking Finance, 21, 895-947

Berger, G. Udell, R. DeYoung and H. Gunay [2000], “Globalization of Financial Institutions: Evidence from Cross Border Banking Performance”, Brookings-Wharton Papers on Financial Services Vol. 3 (2000)

Boot, A.W.A., A.V. Thakor, and G. F. Udell (1987), “Competition, Risk Neutrality and Loan Commitments”, Journal of Banking and Finance, 15, 605-632.

Broecker, T. [1990], “Credit-Worthiness Tests and Interbank Competition”, Econometrica, 58, 2, 429-452

Bouckaert, J. and H. Degryse [2006], “Entry and Strategic Information Display in Credit Markets”, The Economic Journal, 116, 702-720

Caminal, R., and C. Matutes [1997], “Can Competition in the Credit Market be Excessive? ”, CEPR Discussion Paper No 1725, London.

Dell’Ariccia, G. [2001], ”Asymmetric Information and the Structure of the Banking Industry”, European Economic Review, 45, 1957-1980

Dell’Ariccia, G., Friedman, R. Marquez [1999], “Adverse Selection as a Barrier to Entry in the Banking Industry”, RAND Journal of Economics, 30, 515-534

Dixit, A. [1980], “The Role of Investment in Entry Deterrence”, The Economic Journal, 90, 357, 95-106

Ferguson, Niall [1998], The House of Rothschild – Money’s Prophets 1798-1848, Penguin Books

Gehrig, Th. [1998], “Screening, Cross Border Banking, and the Allocation of Credit”, Research in Economics, 52, 387-407

Gehrig, Th. and G. Sheldon [1999], Costs, Competitiveness and the Changing Structure of European Banking, Report to Fondation Banqe de France. Managed by CEPR.

Gehrig, Th. and R. Stenbacka [2001] “Information Sharing in Banking: a Collusive Device?”, Centre for Economic Policy Research, Discussion Paper 2911

Hauswald, R. and R. Marquez [2000], “Relationship Banking, Loan Specialization and Competition”, University of Maryland Working Paper

Kennedy, P. [1989], The Rise and Fall of Great Powers: Economic Change and Military Conflict from 1500 to 2000, Fontana Press

Maksimovic, V. [1990], "Product Market Imperfections and Loan Commitments", Journal of Finance, 45(5), December.

Marquez, R. [2002] “Competition, Adverse Selection and Information Dispersion in the Banking Industry”, Review of Financial Studies, 15, 901-926

Milgrom, P. and J. Roberts [1982] “Limit Pricing and Entry under Incomplete Information: An Equilibrium Analysis”, Econometrica 50, 443-460

Padilla, J.A. and M. Pagano [1997] “Endogenous Communication among Lenders and Entrepreneurial Incentives”, Review of Financial Studies, 10, 205-236

Seelig, S. and T. Critchfield [1999] “Determinants of De Novo Entry in Banking”, FDIC Banking Review, 12(2), 1-14

Spence, A. [1977], “Entry, Capacity, Investment and Oligopolistic Pricing”, Bell Journal of Economics, 8, 534-544

Stiglitz, J and A. Weiss [1981] “Credit Rationing in Credit Markets with Imperfect Information”, American Economic Review, 71, 393-410