Selling Dreams: Endogenous Optimism in Lending Markets

Abstract

We propose a model of borrower optimism in competitive lending markets with asymmetric information. Borrowers engage in self-deception to arrive at beliefs that optimally trade off the anticipatory utility benefits and material costs of optimism. Lenders’ contract design shapes these benefits and costs. The model yields three key results. First, the borrower’s motivated cognition increases her material welfare, which explains why it is not driven out of markets. Second, in line with empirical evidence, a low cost of lending and a booming economy lead to optimism and the widespread collateralization of loans. Third, equilibrium collateral requirements may be inefficiently high. (JEL D82, D86, D91, G21, G31, G51, L26)