Information asymmetry and competition in credit markets: the pricing of overdraft loans in Brazil

This paper evaluates how information asymmetry affects the strength of competition in credit markets. A theory is presented in which adverse selection softens competition by decreasing the incentives creditors have for competing in the interest rate dimension. In equilibirum, although creditors compete, the outcome is similar to collusion. Three empirical implications arise. First, interest rate should respond asymmetrically to changes in the cost of funds: increases in cost of funds should, on average, have a larger effect on interest rates than decreases. Second, aggressiveness in pricing should be associated with a worseing in the bank level default rates. Third, bank level default rates should be endogenous. We then verify the validity of these three empirical implications using Brazilian data on consumer overdraft loans. The results in this paper rationalize seemingly abnormallly high interest rates in unsecured loans.