Monitoring and Market Power in Loan Markets

Whether or not banks are engaged in ex ante monitoring of customers may have important consequences for the whole economy. We approach this question via a model in which banks can invest in either information acquisition or market power (product differentiation). The two alternatives generate different predictions, which are tested using panel data on local banks. We find evidence that banks’ investments in branch networks and human capital (personnel) contribute to information acquisition but not to market power. We also find that managing customers’ money transactions enhances banks ability to control their lending risks.

Introduction: A great deal of empirical evidence supports the hypothesis that banks earn rents (eg Fama 1985, Cosimano and McDonald 1998, Molyneux et al 1994 and the wave of recent bank mergers). In this paper we contrast – within a unified model-ing framework – the two main theoretical explanations for these rents that are pre-sented in the literature and test their empirical validity.A flood of literature (eg Leland and Pyle 1977, Fama 1985, Broecker 1990,Sharpe 1990) suggests that banks’ raison d’etre is to collect and analyze informa-tion, an activity that we refer to as ‘information acquisition’. Banks could, as eg in Broecker’s model, test customers for their creditworthiness in order to avoid ad-verse selection. Such efforts at learning the customer’s type can give the bank an information advantage that can be translated into a larger share of the surplus. An equally old and extensive literature (eg Klein 1971, Degryse 1996) argues that banks’ rents derive from industrial organization-type sources relating to a small number of firms (oligopolistic market), product differentiation, and/or price dis-crimination that is not based on customers’ risk characteristics.We refer to these sources of rents collectively as ‘market power’.

Author: Ari Hyytinen,Otto Toivanen

Source: Research Discussion Papers, Bank of Finland

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