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Monitoring, moral hazard, and market power: a model of bank lending

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Abstract

We model the relationship between market power and both loan interest rates and bank risk without placing strong restrictions on the moral hazard problems between borrowers and banks and between banks and a government guarantor. Our results suggest that these relationships hinge on intuitive parameterizations of the overlapping moral hazard problems. Surprisingly, for lending markets with a high degree of borrower moral hazard but limited bank moral hazard, we find that banks with market power charge lower interest rates than competitive banks. We also find that competition makes banking industry risk highly sensitive to macroeconomic fluctuations by making banks more vulnerable to borrower moral hazard. This finding offers an explanation for the dramatic rise and subsequent decline in bank failure rates during the 1980s and 1990s.

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  • Daniel M. Covitz & Erik Heitfield, 1999. "Monitoring, moral hazard, and market power: a model of bank lending," Finance and Economics Discussion Series 1999-37, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:1999-37
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    7. Hannan, Timothy H., 1991. "Bank commercial loan markets and the role of market structure: evidence from surveys of commercial lending," Journal of Banking & Finance, Elsevier, vol. 15(1), pages 133-149, February.
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    Cited by:

    1. Kirstein, Roland, 2002. "The new Basle Accord, internal ratings, and the incentives of banks," International Review of Law and Economics, Elsevier, vol. 21(4), pages 393-412, May.
    2. Diemo Dietrich, 2003. "Monetary Policy Shocks and Heterogeneous Finance Decisions: A Model of Hidden Effort Choice and Financial Intermediation," German Economic Review, Verein für Socialpolitik, vol. 4(3), pages 365-388, August.
    3. Mustafa Arben & Toçi Valentin, 2018. "The Impact of Banking Sector Competition on Banks’ Risk-Taking in Transition Economies of Central and South-Eastern Europe," South East European Journal of Economics and Business, Sciendo, vol. 13(1), pages 31-42, June.
    4. Gersbach, Hans, 2013. "Bank capital and the optimal capital structure of an economy," European Economic Review, Elsevier, vol. 64(C), pages 241-255.
    5. Godlewski, Christophe J., 2014. "The determinants of multiple bank loan renegotiations in Europe," International Review of Financial Analysis, Elsevier, vol. 34(C), pages 275-286.
    6. Christophe Godlewski, 2004. "Excess Credit Risk and Bank’s Default Risk An Application of Default Prediction’s Models to Banks from Emerging Market Economies," Finance 0409028, University Library of Munich, Germany.
    7. Carletti, Elena, 2004. "The structure of bank relationships, endogenous monitoring, and loan rates," Journal of Financial Intermediation, Elsevier, vol. 13(1), pages 58-86, January.
    8. Giovanni Villani & Marta Biancardi, 2023. "An Evolutionary Game to Study Banks–Firms Relationship: Monitoring Intensity and Private Benefit," Computational Economics, Springer;Society for Computational Economics, vol. 61(3), pages 1075-1093, March.
    9. Mr. Gianni De Nicolo & John H. Boyd, 2003. "Bank Risk-Taking and Competition Revisited," IMF Working Papers 2003/114, International Monetary Fund.

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    Keywords

    Bank loans; Banks and banking;

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