More banks mean higher costs for borrowers

(Press-News.org) When banks crowd a lending market, you can forget the traditional relationship of supply and demand, in which increased supply normally leads to lower prices. So finds new research from Cesare Fracassi, associate professor of finance at Texas McCombs.

Paradoxically, a larger number of banks in a market sends the price of a loan up — as measured by the interest rate charged by the lender. For every six additional banks in a county, he finds, interest rates are 7 basis points higher. A basis point is one-hundredth of 1%.

“The usual story we tell says the more suppliers of a product are out there, the better it is,” Fracassi says. “It’s not true when it comes to loans.”

Fracassi investigated the ties between bank competition and loan pricing with Mehdi Beyhaghi of the Federal Reserve Board and Gregory Weitzner of McGill University. They reviewed Federal Reserve records of more than 20,000 U.S. bank loans over $1 million during 2014-2019. The data included both terms of loans and banks’ internal estimates of how likely a borrower is to default.

That probability depends partly how much or how little a bank knows about a borrower. “If a borrower comes in and asks for a loan, some banks might be better at screening applicants than others,” Fracassi says.

Such imbalances in information can matter when one bank approves a borrower whom other bankers have previously turned down. The more banks in a market, the greater the fear that the lender might have missed hidden bad news about the borrower. To protect itself, the bank boosts the interest rate.

“Instead of giving a really good rate, you give a higher rate because you want to be conservative and say, ‘Hey, this person might actually default,’” says Fracassi.

He compares the dynamic to one known as the winner’s curse. If you win at an art auction in which many people bid, it’s likely you got a bad deal, he says. You were the one who was willing to part with the highest amount of money.

Besides inspiring banks to charge more for loans, competition also led to more loans and riskier ones. One additional bank in a market was associated with:

Higher lending volume of 14%. A 1.1 basis point increase in probability of default. Higher risk wasn’t the only factor that boosted interest rates. When a company got multiple loans from the same bank, it faced markups of 9 basis points — presumably because the bank now knew more about the borrower and the borrower’s risks.

The result is a counterintuitive lesson, Fracassi says. Having fewer banks can sometimes help borrowers and local economies. In more concentrated markets, banks worry less about the winner’s curse and may offer better rates.

For that reason, he cautions regulators to be careful about blocking mergers or forcing banks to shed branches simply to boost competition. “We say sometimes, it actually is good to have fewer banks,” he says.

For small businesses, he adds, bank concentration might be one factor to consider when choosing a market to enter.

“If you are a really good small business, you might want to go to an area where there are very few banks,” Fracassi says. “But if you are somebody that got rejected from all the other banks, you might want to be in a place where there are a lot more banks, so you can shop around.”

“Adverse Selection in Corporate Loan Markets” is published in The Journal of Finance.

 

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