Relationship lending and competition: Higher switching cost does not necessarily imply greater relationship benefits

This paper studies relationship lending in a framework where the cost of switching banks measures the degree of banking competition. The relationship lender’s (insider bank’s) informational advantage creates a lock-in effect, which is at its height when the switching cost is infinitesimal. This is because a low switching cost gives rise to a potential adverse selection problem, and outsider banks are thus reluctant to make overly aggressive bids. This effect gradually fades as the magnitude of the switching cost increases, which de facto reduces the insider bank’s profits. However, after a certain threshold in the switching cost, the insider bank’s ‘mark-up’ begins to increase again. Hence, relationship benefits are a non-monotonous (V-shaped) function of the switching cost. The ‘dynamic implication’ of this pattern is that relationship formation should be more common under extreme market structures ie when the cost of switching banks is either very low or sufficiently high. Recent empirical evidence lends support to this prediction.relationship lending; switching cost; banking competition

Relationship lending and competition: Higher switching cost does not necessarily imply greater relationship benefits

This paper studies relationship lending in a framework where the cost of switching banks measures the degree of banking competition. The relationship lender’s (insider bank’s) informational advantage creates a lock-in effect, which is at its height when the switching cost is infinitesimal. This is because a low switching cost gives rise to a potential adverse selection problem, and outsider banks are thus reluctant to make overly aggressive bids. This effect gradually fades as the magnitude of the switching cost increases, which de facto reduces the insider bank’s profits. However, after a certain threshold in the switching cost, the insider bank’s ‘mark-up’ begins to increase again. Hence, relationship benefits are a non-monotonous (V-shaped) function of the switching cost. The ‘dynamic implication’ of this pattern is that relationship formation should be more common under extreme market structures ie when the cost of switching banks is either very low or sufficiently high. Recent empirical evidence lends support to this prediction.relationship lending, switching cost, banking competition

Asymmetric information in credit markets and entrepreneurial risk taking

The paper constructs a search-theoretic model of credit markets with a bilateral trading mechanism that enables the manageable introduction of asymmetric information. Borrowers´ success probabilities are unobservable to financiers, but the degree of risk in observable projects can be used as a sorting device. We find that the efficiency of a perfect Bayesian equilibrium depends negatively/positively on the credit market ´tightness´/liquidity. In general equilibrium, where the underlying market conditions are endogenously determined, steady states with greater credit market tightness are always associated with increasingly excessive investment in risky projects. Since tighter market conditions also imply less intense competition among financiers, the commonly asserted trade-off between competition and efficiency does not emerge. Tighter monetary policy is shown to worsen the adverse effect of informational frictions on efficiency.credit market; asymmetric information; search; risk taking

Portfolio effects and efficiency of lending under Basel II

Although beneficial allocational effects have been a central motivation for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less discussed. In this paper, we investigate the effect of Basel II on the efficiency of bank lending. We consider competitive credit markets where entrepreneurs may apply for loans for investments of different risk profiles. In this setting, excessive risk taking typically arises because low risk borrowers cross-subsidize high risk borrowers through the price system that is based on average success rates. We find that while flat-rate capital requirements (such as Basel I) amplify overinvestment in risky projects, risk-based capital requirements alleviate the cross-subsidization effect, improving allocational efficiency. This also suggests that Basel II does not necessarily lead to exacerbation of macroeconomic cycles because the reduction in the proportion of high-risk investments softens the cyclicality of bank lending over the business cycle.Basel II; bank regulation; capital requirements; credit risk; procyclicality

The effect of a transaction tax on exchange rate volatility

We argue that a transaction tax is likely to amplify, not dampen, volatility in the foreign exchange mar-kets. Our argument stems from the decentralised trading practice and the presumable discrepancy be-tween ‘informed’ and ‘uninformed’ traders’ valuations. Since informed traders’ valuations are likely to be less dispersed, a transaction tax penalises informed trades disproportionately, leading to increased volatil-ity. Empirical support for this prediction is found by investigating the effect of transaction costs on the volatility of DEM/USD and JPY/USD returns. High-frequency data are used and an increase in transac-tion costs is found to have a significant positive effect on volatility.transaction tax; exchange rates; volatility

Credit allocation, capital requirements and output

We show how banks’ excessive risk-taking, stemming from informational asymmetries in loan markets, can lead to an excessive output loss when a recession starts. Risk-based capital requirements can alleviate the output loss by reducing excessive risk-taking in ‘normal’ times. Model simulations suggest that the differentiation of risk-weights in the Basel framework might be further increased in order to take full advantage of the allocational effects of capital requirements. Our analysis also provides a new rationale for the countercyclical elements of capital requirements.bank regulation; Basel III; capital requirements; credit risk; crises; procyclicality

Credit allocation, capital requirements and procyclicality

Although beneficial allocational effects have been a central motivator for the Basel II capital adequacy reform, the interaction of these effects with Basel II’s procyclical impact has been less discussed. In this paper, we investigate the effect of capital requirements on the allocation of credit and its interaction with procyclicality, and compare Basel I and Basel II type capital requirements. We consider competitive credit markets where entrepreneurs of varying ability can apply for loans for one-period investment projects of two different risk types. The risk of a project further depends on the state of the economy, modelled as a two-state Markov process. In this type of setting, excessive risk taking typically arises because higher-type borrowers cross-subsidize lower-type borrowers via a pricing regime based on average success rates. We find that risk-based capital requirements (such as Basel II) alleviate the cross-subsidization effect and can be chosen so as to implement first-best allocation. This implies that the ensuing reduction in the proportion of high-risk investments may mitigate the procyclical effect of Basel II on economic activity. Moreover, we find that optimal risk-based capital requirements should be set lower in recessions than in normal times. Our simulations show that when measured by either cumulative output or output variation, Basel II type capital requirements may actual be slightly less procyclical than flat capital requirements. The biggest reduction in procyclicality is however achieved with optimal risk-based capital requirements which are considerably higher than Basel II requirements and which are adjusted downwards in recession periods.Basel II; bank regulation; capital requirements; credit risk; procyclicality