Banking (conservatively) with optimists

Commercial banks frequently encounter optimistic entrepreneurs whose, perce ptions are biased by wishful thinking. Bankers are left with a difficult sc reening problem: separating realistic entrepreneurs from optimists who may be clever, knowledgeable, and completely sincere. We build a game-theoretic model of the screening process. We show that although entrepreneurs may pr actice self-restraint to signal realism, competition may lead banks to be i nsufficiently conservative in their,lending, thus reducing capital-market e fficiency. High collateral requirements decrease efficiency further. We dis cuss bank regulation and bankruptcy rules in connection with the problems t hat optimistic entrepreneurs present.