The adverse selection problem in imperfectly competitive financial markets

We show that two horizontally differentiated banks can implement separating equilibria in markets for bank loans by using non-linear price schedules. The optimal strategies of the banks induce 'high-risk' borrowers to patronize their preferred, that is closer, bank. 'Low-risk' borrowers accept offers from their less preferred bank, which offers lower interest rates. The revelation mechanism is sensitive to the degree of competition between the banks, and credit rationing will be minimized at an intermediate level of competition. Copyright 2013 Oxford University Press 2012 All rights reserved, Oxford University Press.