Bargaining over loan contracts with 'market-savvyness' signaling

Abstract

We combine a sequential bargaining game between banks and an entrepreneur about loan contracts with a signaling game in which the entrepreneur invests ex ante in the quality of her loan application. The higher ability type of the entrepreneur is characterized by a greater `market-savvyness' on the lending market rather than by a greater quality of her investment project. We characterize subgame-perfect Nash equilibrium loan contracts that are supported by separating Bayesian equilibria in the signaling game. Two novel findings emerge form our analysis. Firstly, lower quality investment projects might be rewarded with more favorable loan conditions. Secondly, socially wasteful signaling costs increase in the number of banks so that a banking monopoly maximizes the aggregate welfare in our model.