Lending terms and aggregate productivity

Several empirical studies suggest that lending terms are eased in expansions and tightened in recessions, thereby influencing the mix of financed entrepreneurs. We study a model of adverse selection in competitive financial markets and show that lending terms deteriorate with the aggregate state under two general conditions. If exogenous increments to entrepreneurs׳ productivity raise returns to investment and/or tighten the credit line needed to screen out a given entrepreneur type, competition results in contracts with less screening. Two endogenous effects on productivity emerge. Production scales grow closer to optimal, but lower productivity entrepreneurs enter the mix of producers. The positive (negative) effect dominates at low (high) aggregate states.