Adverse Selection of Borrowers Prone to Delusion

Abstract

We study a lender-borrower relationship in which borrowers differ along a privately known dimension of risk and can engage in wishful thinking, believing that they belong to a different risk class in order to savour a higher anticipatory payoff. Uninformed lenders may attempt to separate borrowers by introducing collateral requirements in their contract offers, but the potential for delusion puts constraints on such separation. We find that both monopolistic and competitive credit markets may give rise to equilibrium delusion and pooling contracts with positive collateral. As the cost of funds faced by competitive lenders becomes smaller, we are more likely to observe an equilibrium with collateral requirements on both types and delusion on behalf high-risk borrowers.