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Working Papers (2014), ESSEC Business School

Optimal Return in a Model of Bank Small-business Financing

This paper develops a simple model showing how banks can increase the access to finance of small, risky firms by mitigating coordination problems among investors. If investors observe a biased signal about the true implementation cost of real sector projects, the model can be solved for a switching equilibrium in the classical global games approach. We show that the socially optimal interest rate that maximizes the probability of success of the firm is higher than the risk-free rate. Yet if banks maximize investors' expected return, they would choose an interest higher than the socially optimal one. This gives rise to a form of credit rationing, which stems from the funding constraints of the banks.

PEIA, O. and VRANCEANU, R. (2014). Optimal Return in a Model of Bank Small-business Financing. ESSEC Business School.