Endogenous product differentiation in credit markets: What do borrowers pay for?

Abstract

This paper studies strategies pursued by banks in order to differentiate their services from those of their rivals. In that way the level of competition in the industry is reduced. More specifically we analyze whether the bank size, a bank's ability at avoiding losses, or its capital ratio can be used as strategic variables to make banks different and increase the interest rates banks can charge their borrowers in equilibrium. Using a panel of data covering Norwegian banks between 1993 and 1998 we find empirical support for the the ability at avoiding losses measured by the ratio of loss provisions as such a variable. Borrowers in the market for credit line loans may discipline banks into avoiding losses. We also find evidence that banks pass on parts of increases in their operating costs to credit line borrowers. However, we do not find any strong evidence for the use of high capital ratio as a strategic variable that borrowers are willing to pay for. This implies that strategic competition does not lead banks to hold more capital than their cost minimizing level. Thus, our paper gives support to the rationale for imposing capital requirements on all banks. JEL code: G21 L15Preliminary version * Views and conclusions expressed are the the responsibility of the authors alone and cannot be attributed to Norges Bank.

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