Claim 2:

The interest rate and the projects’ risk in a competitive equilibrium are characterized by

the elasticity of supervision cost z with respect to the project’s probability of success, l -jx electronic-loan.com.

Proof – Equation (7a) follows directly from maximizing the bank’s expected income, (6), with respect to the project’s risk, fi. It equates the marginal benefit of risk reduction (the LHS of (7a)) with its marginal cost (the RHS of (7b)). Competition among banks induce rent dissipation. Hence, the borrowing interest rate is determined by

The resultant equilibrium is characterized by Figure II, drawn for the case where H = 1. The bold curve is the bank’s cost of a 1$ loan [i.e., г(Д) + (1 + гс)1].

The downward sloping line, cc, is the expected repayment per unit loan. Free entry and optimal monitoring implies an equilibrium at the tangency of the expected repayment line and the bank’s unit cost line, determining Д.

The productivity of the marginal project, denoted by x, is determined by the rent dissipation condition,

In a competitive equilibrium entrepreneurs will finance all the projects characterized by x