Informational switching costs, bank competition, and the cost of finance

Summary

Focus

We test two theories of banking competition. The first is the market power hypothesis, which claims that higher market power leads to financial constraints and wider spreads. The second is the information hypothesis, which argues that banks need some market power to offset their lack of knowledge of borrowers ( "information asymmetry") in lending markets. According to the information hypothesis, less competition induces banks to engage in relationship lending. In this way, banks might obtain more soft information and so reduce the effects of information asymmetry. On this view, increased competition would lessen the attractiveness of relationships and increase the cost of credit.

Contribution

We analyse more than 13 million loans by private sector banks to firms in Brazil from 2005 to 2016. The use of loan-level data lets us better disentangle demand and supply factors. It also lets us identify shocks more accurately than in previous work, as we have information on the bank-firm relationship over time. Furthermore, we use a competition measure – the Lerner index – at a bank instead of a country-wide level. This lets our study benefit from variation both across banks and through time.

Findings

Our results show a direct relationship between the market power of private banks and spreads. They show that less competition increases the cost of firm financing, in line with the market power hypothesis. Another key finding is to demonstrate that banks follow a "capture then extract rents" strategy in Brazil. Banks first capture some of their clients by offering lower interest rates, later increasing these rates as the relationship evolves. This suggests that it pays banks to keep firms as clients, to avoid any informational switching costs. This evidence argues against the information hypothesis. On this view, policy responses seeking to foster information-sharing may help to reduce switching costs and hence alleviate the effects of lock-in.

Abstract

This paper studies the links between competition in the lending market and spreads of bank loans in Brazil. Evidence from a dataset of more than 13 million loan-level observations from private banks shows a positive relationship between market power, measured by the Lerner index, and the cost of finance, measured by loan spreads over the treasury curve. Furthermore, there is evidence of the holdup problem, originating from informational switching costs faced by firms. Private banks engage in a strategy of first competing fiercely for clients by offering a lower loan interest rate and later increasing interest rates as the bank-firm relationship duration increases. Both results are stronger for micro and small firms than for medium and large firms.

JEL classification: D43, G21, L10, L14.

Keywords: banking, competition, switching costs, information asymmetry, holdup problem, lock-in.