Bad Loans and Entry into Local Credit Markets

Is deregulation sufficient to grant free entry in local credit markets? Economic theory suggests at least two ways in which asymmetric information between incumbents and entrants can work as an endogenous barrier to entry. First, entrants� pool of applicants contains a larger share of potential customers who are not creditworthy because it includes all those would-be borrowers who were previously rejected by mature banks in the market. Second, since a substantial amount of the information used by banks to screen loan applicants and monitor borrowers is generated through repeated interaction with their customers and the local business community, incumbents� creditworthiness tests are likely to be more accurate. Other things being equal, entrants are therefore expected to experience higher loan default rates than incumbents. Using a unique database of 7,275 observations on 729 individual banks� lending in 95 Italian local markets, we find that both adverse selection and informational disadvantage play a significant role in explaining entrants� loan default rates. We argue that these endogenous barriers can help to explain why in many local credit markets by domestic and foreign banks was slow, even after substantial deregulation.