Asymmetric Information, Bank Lending and Implicit Contracts: A Stylized Model of Customer Relationships

Abstract

Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation. Wood (1975). According to this view, an essential factor underlying a bank's loan pricing policy is its impact on the bank's stock of loyal customers, as well as on those customers' deposits. Rather than take relationships as a given, we examine the implications of the view expressed, for example, by Fama (1985), that they arise because of "inside information" generated by the history of bankfirm interactions. THIS PAPER DERIVES A dynamic theory of "customer relationships" in bank loan markets. The theory builds on a traditional view of bank lending behavior, first spelled out by Hodgman (1961) and Kane and Malkiel (1965) and later elaborated upon byIn our theory, customer relationships arise endogenously as a consequence of the asymmetric evolution of information sets. In contrast with most theories of pricing under asymmetric information, though, the key informational asymmetry postulated here is that which arises between agents on the same side of the market. We exploit the presumption, made by Kane and Malkiel (1965) and Fama (1985), that a bank which actually lends to a firm learns more about that borrower's characteristics than do other banks. A fundamental consequence of this asymmetric evolution of information is the potential creation of ex post, or temporary, monopoly power.If it is relatively costly for banks and firms to write multiperiod contingent contracts, this ex post monopoly power has undesirable effects on the allocation of capital. Even though banks earn zero expected profit over the lifespan of the average customer relationship, they are not disciplined by the market to offer * Division of Research and Statistics, Board of Governors of the Federal Reserve System. The views expressed herein are the author's and do not necessarily reflect those of the Board of Governors or the Federal Reserve System. I am grateful to Mordecai Kurz and members of his student workshop, as well as John Duca, Anjan Thakor, Gregory Udell, and an anonymous referee for their valuable comments and suggestions. 1069 1070The Journal of Finance better-performing customers "competitive" rates and, thus, can expect to earn economic profit on those customers. Due to competition, however, rents are competed away via lower interest rates on loans offered to all firms in their initial period, precisely when banks know the least about firms. As a result, low quality firms employ a greater p...

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