Positive Profits in Competitive Credit Markets With Adverse Selection

We analyze competitive credit markets with asymmetric information in which borrowers seek financing for either positive or negative net present value projects. The striking result is that there always exists an equilibrium where investment is efficient, while competitive lenders make strictly positive profits. When borrowers have zero opportunity costs of investment, this equilibrium co-exists with a market breakdown. With opportunity costs, no matter how small, the market can never break down, while the positive-profits equilibrium is unique if the average project quality is sufficiently low. This equilibrium exists even if borrowers can offer menus of contracts, and it coincides with the unique incentive compatible menu when almost all types have a negative net present value project. As lender profits can be taxed without distortions, we characterize the incentive compatible redistributions