Risk-based pricing in competitive lending markets

Summary

Focus

We estimate the impact of competition on the way banks price the risk of default when giving credit to firms. When competition is strong, banks might be willing to offer lower interest rates to attract firms. In addition, banks might put less effort into examining the risks and then offer a rate based on less precise information. We use supervisory data on banks in Norway between 2012 and 2018. Competition varies substantially across the country's different geographical regions. We study how banks adapt their price-risk relationship across different regions to the level of competition.

Contribution

Banks' first line of defence against losses is their operating income. Being adequately compensated for taking risks is therefore a key ingredient for bank solvency and ultimately financial stability. Previous research has not studied how banks price risks because banks do not usually share their risk assessments. Without this information, it is hard to determine whether a low interest rate is due to strong competition or private factors that signal low risks to the bank. Our data let us overcome this challenge. We show that the pricing of default risk is a strategic component in banks' reaction to competition.

Findings

We verify that banks' estimates of firm default risk contain more than just public information and that competition does not lessen the value of the information in these estimates. We document that a higher risk estimate is associated with higher interest rates but that this relationship is weaker in competitive environments. We show that banks earn lower risk-adjusted returns on regional loan portfolios in more competitive markets. Banks that operate with low profitability and low equity are usually more prone to react to competitive pressures. We confirm that these banks are driving our results. Our findings therefore show an association between competition and fragility.

Abstract

We use unique relationship-level data which includes banks' private risk assessments of corporate borrowers to quantify how competition among banks affects the risk sensitivity of interest rates in the corporate credit market. We show that an increase in competition makes corporate lending rates less sensitive to banks' own assessment of borrower probability of default and this is more pronounced in market segments with a higher degree of asymmetric information. Our results are driven by banks with low franchise values, outlining a novel channel of how the competition-fragility nexus can operate.

JEL classification: G21, G28

Keywords: banking competition, relationship lending, credit markets, risk-based pricing, financial stability