Academic journal article Journal of Money, Credit & Banking

Signal Jamming in New Credit Markets

Academic journal article Journal of Money, Credit & Banking

Signal Jamming in New Credit Markets

Article excerpt

LENDERS INITIATING CREDIT RELATIONS with new borrowers frequently face problems due to imperfect information. If these problems cannot be fully resolved prior to the actual incidence of borrowing, then the subsequent interaction between the lender and borrower can be an effective means of assessing the repayment capability of the borrower. During this interaction, client-specific information is likely to be revealed to the inside lender. On the other hand, this information will generally be less available to outside lenders in the credit market. Based on this information asymmetry, an inside lender may find that he can extract some rent from his older clients. This has been demonstrated in models by Sharpe (1990) and Rajan (1992), and tested for in Peterson and Rajan (1995). The amount of rent an inside lender is able to appropriate from his clients is partially dependent on the quality of the client-specific information available to outside lenders. In most models, the quality of this externalized information flow is assumed to be largely exogenous to the decisions of the lenders and borrowers. The contribution of the present paper is to make this feature endogenous. We develop a two-period model in which an inside lender's first-period contract offer affects the degree to which outside lenders can learn borrowers' risk types by observing credit histories. In this context, we demonstrate that a lender may have an incentive to implement a two-period strategy to manipulate or signal jam the flow of information.

The results of our research on credit markets share some theoretical similarities with findings in two other literatures. In the industrial organization literature, Fudenberg and Tirole (1986) develop a model where an incumbent firm faces competition from an entrant who must infer his own cost by observing current-period profits, over which the incumbent firm has some influence. Under these conditions, it is shown that the incumbent firm may be willing to tolerate low profits in order to signal jam the entrant's inference process about his cost. Building on this result, Mirman, Samuelson, and Urbano (1993), Mirman, Samuelson, and Schlee (1994), and Creane (1996) examine problems in which a firm's decision regarding production level affects the market price and ex post, the price then reveals information about demand to competing firms. Under these conditions, research suggests that firms may adjust away from myopically optimal levels in order reduce the informativeness of price to outside competitors.

In a separate literature, Waldman (1984), Gibbons and Katz (1991), Laing (1994), and Bernhardt (1995) examine employer-employee relations when employers begin with little or no information on employees. In these models, an employer gains an information advantage on her employees over other outside employers during the course of employment. Based on this asymmetry, Gibbons and Katz (1991) make some theoretical predictions about employer behavior and find support for their predictions using empirical work. Other models, such as in Waldman (1984) and more recently Bernhardt (1995), study incentives for the employer to adopt strategies similar to the signal-jamming strategies studied in industrial organization. For example, in the labor market current employers may have an incentive to distort their decisions about promoting and terminating employees in order to weaken an outside employer's capacity to infer which workers are high quality and which are low quality.

The model developed in our paper begins by assuming that a lender has imperfect information on a set of heterogeneous borrowers. Of course, there is a large literature on this type of problem. For example, Stiglitz and Weiss (1981) study how adverse selection can lead to credit rationing in equilibrium, and Bester (1985) and Webb (1991) examine how lenders can use contractual design to screen heterogeneous borrowers. …

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