We empirically examine the hypothesis that access to deposits with inelastic rates (core deposits) permits a bank to make contractual agreements with borrowers that are infeasible if the bank must pay market rates for its funds. Access to core deposits insulates a bank's costs of funds from exogenous shocks, allowing the bank to insulate its borrowers against exogenous credit shocks. Using a large sample of loans from the Survey of Terms of Bank Lending, we find that, controlling for competitive conditions in loan markets, banks funded more heavily with core deposits provide more smoothing of loan rates in response to exogenous changes in aggregate credit risk. This suggests that a distinctive feature of bank lending is that firms and banks form multiperiod lending relationships, in which loans need not break even period by period. It also partially explains the declining share of bank loans (or near substitutes for bank loans) in credit markets. As banks have increasingly been forced to pay market rates for an increasing share of their funds, multiperiod relationship lending has become increasingly less feasible and bank loans have lost some of their comparative advantage over securities. Our results suggest that access to core deposits is one of the foundations of relationship lending.
This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants based on noisy indicators of the firm's financial health and loan contracts enforced by a monitoring specialist. In one interpretation, the specialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indicators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring.
an anonymous referee, seminar participants at the Board of Governors, the 1993 BRC/JFI Symposium on Financial Institutions, and the 1993 Western Finance Association meetings for helpful comments and discussions. They are not responsible for any remaining errors. Berlin thanks the Leonard N. Stern School of Business and the Indiana University School of Business for financial support. John thanks the Charles William Gerstenberg Chair and the Bank and Financial Analysts Association Faculty Fellowship for financial support. Saunders thanks the John M. Schiff Chair for financial support. The views expressed here are ours and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
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