Entry deterrence in banking: the role of cost asymmetry and adverse selection

Abstract In this paper, we review and explore the strategic mechanisms that deter entry in banking. The literature relies on externality between banks to generate entry deterrence. Typically, the externality generated is caused by differential adverse selection faced by incumbents and entrants. In this paper it is shown that adverse selection problem between a bank and its borrowers is neither a necessary nor a sufficient condition for entry deterrence. We show that cost asymmetry between different types of incumbents and private information about costs can generate conditional entry deterrence. This source of externality can cause entry deterrence just as other types of externalities created by differential adverse selection. Forward contracts can act as signaling device for incumbent costs. Incorporating adverse selection problem in the credit market in fact relaxes entry conditions: entry can take place even if the incumbent is of strong type and can signal credibly.