Department of Economics. University of Melbourne. Parkville Victoria 3052 Australia
ABSTRACT
In standard models of asymmetric information in credit markets, borrowing agents are assumed to require capital to finance individual projects. It is well known that with indivisible capital requirements, asymmetric information can result in credit rationing. Collateral can eliminate the credit rationing outcome but may introduce a different type of inefficency. In more recent literature, captial requirements are assumed divisible. With divisible capital, loan size can serve as an effective signal and generally displaces the role of collateral as a mechanism for improving the credit market outcome. In this paper, borrowing agents require capital to finance competitive bids for a single productive asset rather than requiring capital for individual projects. Loan size is no longer effective as a signaling mechanism. Instead, high quality agents will either offer a sufficiently high level of collateral to signal their type or choose to pool with low quality agents. A pooling equilibrium will emerge if the implicit cost of signaling is too high but then high quality borrowers must bid against all borrowers rather than only their own type.
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