Ebook Endogenous product differentiation in credit markets: What do borrowers pay for?
What do borrowers pay for? Are borrowers willing to pay higher rates to banks exhibiting higher reputation? If this is the case, some banks would invest in reputation for quality and differentiate their services from their rivals, thereby softening competition. In this paper we focus on such endogenous differentiation among banks. More precisely, which ‘‘quality’’ characteristics (equity ratios, loss avoidance, size etc.) do banks choose in order to differentiate themselves from competing banks.
There are two major reasons for borrowers to be concerned with bank quality. First, banks provide certification which can be used to alleviate consequences of asymmetric information and to contribute to borrowers’ value. By borrowing from a bank known to have a high-quality loan portfolio (i.e. low loan-loss provisions) a firm can signalits creditworthiness to its other stakeholders. In this manner a high quality bank certifies its borrowers. Thus, banks can segment the markets according to borrowers’ willingness to pay for borrowing from banks with high-quality loan portfolios and extract higher rents from those valuing certification.
Second, borrowers may be concerned with refinancing. Refinancing is of crucial interest for locked-in customers. Some borrowers may face large lock-in effects due to the fact that their current bank has an informationalad vantage vis a vis competing banks (see Sharpe, 1990). These borrowers are inclined to choose banks that they anticipate are able to extend credit lines or provide new loans in future periods (switching to another bank is costly, see Kim et al., 2003). This suggests that bank characteristics that are informative about a bank’s ability to provide loans in the future, as reflected in bank solvency and diversification (size), are important for borrowers. Well diversified and well capitalized banks will less likely face large losses and are more able to withstand potential losses. Locked-in borrowers may prefer such banks (see Chemmanur and Fulghieri, 1994).
The major interest of the empiricalpa rt of this study is to distinguish between the certification and refinancing motives. If borrowers pay a premium for borrowing from banks providing certification (low loan-loss provisions) or from solvent banks with few problems in meeting future refinancing needs, banks face market discipline induced by borrowers. This asset side market discipline effect is different from the conventional one on the liability side (uninsured deposit and money market funding), which has been extensively studied in the banking literature. A possible disciplinary effect from borrowers may reinforce the market disciplinary effect stemming from the liability side and make banks less financially fragile.
The issue of product differentiation in banking has been of interest for some time. Generally, banks can pursue two kinds of differentiation strategies. A bank can differ from other banks in a way that all customers consider as better than its competitors (e.g., better services). When customers agree about the quality ranking of different banks at equalprices , we callit vertical product differentiation. In contrast, horizontal product differentiation does not imply that all borrowers agree about such a ranking. For example, a bank may move a branch from one city to another, to the benefit of customers in the latter city.
The empirical literature on product differentiation in banking has mainly been concerned with horizontal differentiation. See Matutes and Vives (1996); Berg and Kim (1998); Barros (1999), and Kim and Vale (2001). Degryse (1996) theoretically analyzes the interaction of horizontal and vertical differentiation. See also Anderson et al. (1992). 5 The present paper, however, focuses on verticalpro duct differentiation since we are interested in the effect of reputation for quality which is intrinsically a vertical differentiation phenomenon.
In the present paper we restrict our attention to debt taken from the banking sector only. This is because most European countries have relatively thin markets for arm’s length debt (bonds and certificates). OECD statistics show that bond and certificates as of 1995 comprised only around 4.0%–6.0% of total funding for the private non-financialfirms in Europe (see OECD, 1996).
Before conducting the empiricalanal ysis, we provide a stylized, two-stage, theoretical model which can shed some light on ways banks can utilize borrower heterogeneity in order to differentiate themselves. In the empirical part, we use data from the Norwegian banking industry to illustrate along which dimensions banks may find it most profitable to differentiate and soften competition.
The paper is organized in the following way: Section 2 presents our stylized theoretical model which illustrates some of the main forces behind product differentiation; Section 3 describes the data used, variables calculations, and the empirical model. Empirical results and discussion are presented in Section 4. Section 5 concludes the paper.
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