Tough Private Lenders Competing Against Soft State Banks

In many economies, small and medium-sized firms have no direct access to the financial markets but depend on bank loans. In the market for bank loans, competition is often distorted by state banks enjoying lower funding costs than private banks due to a state guarantee on their liabilities. In this paper, we argue that if the state bank’s guarantee is tied to an obligation to renegotiate loans of firms in financial distress, i.e., the state bank is a ’soft’ lender, a private bank can induce firms to separate by self-selection through committing itself to a policy of tough liquidation. This reduces information asymmetries in the market and allows the private bank to lend to high-quality firms at favorable rates. As the result, the borrower pool of the bank improves and it obtains profits in equilibrium. JEL Classifications: G33, G21