Interest rates and information

In a lending relationship, a bank learns information on its borrowers. Adverse selection makes the usefulness and value of this information depend on the interest rates the bank charges in the different periods. The optimal intertemporal screening of borrowers calls for a monopolistic bank to smooth interest rates. In a repeated relationship, interest rates are lower than in a one-period setting; furthermore, they are less volatile and the quality of the loans is higher than under competition (with symmetric information). Information sharing may reduce both the probability that a debt will be paid and the sum of banks’ and borrowers’ profits.