Credit Mismatch and Breakdown
Southern Illinois University
Victor E. Li
Washington University in St. Louis and NBER
Abstract: This paper studies the phenomenon of mismatch in a decentralized credit market where
borrowers and lenders must engage in costly search to establish credit relationships. Our dynamic
general equilibrium framework integrates incentive based informational frictions with a matching
process highlighted by (i) borrowers’ endogenous market entry and exit decision (entry frictions) and
(ii) time and resource costs necessary to locate credit opportunities (search frictions). A key feature
of the incentive compatible loan contract negotiated between borrowers and lenders is the interaction
of informational frictions (in the form of moral hazard) with entry and search frictions. We find that
the removal of entry barriers can eliminate information-based equilibrium credit rationing. More
generally, entry and incentive frictions are important in understanding the extent of credit rationing,
while entry and search frictions are important for understanding credit market breakdown.
JEL Classification: C78, D82, D83, E44.
Keywords: Entry, Moral Hazard, Credit Rationing, Credit Mismatch, Credit-Market Breakdown.
Acknowledgment: We are grateful for valuable suggestions from Derek Laing, Yiting Li, Steve
Williamson, and seminar participants at City University of Hong Kong, Osaka University, Vanderbilt
University, Washington University in St. Louis, Midwest Macro Meetings, SAET Conference, and
Summer Meetings of the Econometric Society. Financial supports from Academia Sinica and the
Weidenbaum Center on the Economy, Government, and Public Policy to enable this international
collaboration are gratefully acknowledged. Needless to say, the usual disclaimer applies.
Correspondence: Ping Wang, Department of Economics, Washington University in St. Louis, St.
Louis, MO 63130-4899, United States; Phone: 314-935-5632; Fax: 314-935-4156; E-mail: ping-