The Effect of Credit Market Competition on Lending ...mkredler/ReadGr/AllubOnPetersenRajan95.pdf · A monopolistic creditor ... CM competition limits the ability to share surplus

The Effect of Credit Market Competition on Lending

Relationships

Petersen and Rajan

by Lian Allub-UC3M

23/04/2014

Petersen and Rajan (by Lian Allub-UC3M) The Effect of Credit Market Competition on Lending Relationships23/04/2014 1 / 10

Introduction

Is it possible strong ties in competitive credit markets?

Imagine a firm with:I Capital needs todayI Potential high future profits

With competitive credit marketsI Lender can not share future surplus with creditorI Creditor should break even period-by-periodI May charge high interest rate until uncertainty is resolved

A monopolistic creditorI Can share profit with the firmI May subsidize r in the beginning and charge a higher r in the future.

CM competition limits the ability to share surplus intertemporally.I Makes lending relationships less valuable


This Paper

Develop a model with different degree of CM competition

Use data from the Natiaonal Survey of Small Business and Finances(1987)

I Data from nonfinancial, non farm small businessesI Firms with less than 500 employeesI Stratified sample to ensure large and rural firms to be represented

Focus analysis in Small businesses in the USI Concentrate their external borrowing in banks

Use variability of competition in different regions of the country

Study how CM competition affects external financing of firms


Model: Agents and Investment Opportunities

Risk neutral world

2 type of agents looking for financing: good and bad entrepreneurs

At time 0, 2 types of project to invest I0:I Safe project

F Pays S1 in period 1F Can invest I1s in another safe project that pays S2 in period 2

I Risky projectF Pays R1 with probability p and 0 with probability 1− pF If succeeds, can invest I1r in a safe project that pays R2

Bad entrepreneurs always fail and obtain 0 in period 1

A.1 S2 + S1 − I1S − I0 > 0 Safe project has positive NPV

A.2 p(R2 + R1 − I1R)− I0 < 0 Risky project has negative NPV

A.3 pR2 = S2 > pI1R = I1S Same expected returns and investment

A.3 I1S > R1 > S1 Need to borrow at period 1


Model: Finance

Banks are the only source of external finance

Agents know whether they are good or bad

At date 0 banks only know that a proportion θ are good entrepreneurs

At date 1 banks become fully informed

Banks can only hold debt claims (Contracts that require a fix payment)

Contracts can not be contingent on the project or the type of agent

Bank can charge a rate such that its expected return is M

M will be the market power (assume risk free rate is 0)I Competitive market → M = 1I Concentrated market → M > 1

A.5 S2/I1S > M ≥ 1


Model: Solving the Model

Good entrepreneurs try to reduce their cost of borrowing:I Borrow as little as possible in the first periodI Proposes to pay D1 at period 1 and contract a new loan

For the bank to lend at date 0 we need two conditions:I Loan structured so that the entrepreneur invest in the safe projectI The bank must expect to recover i0 in period 1

The bank will lend only if: D1 ≥ I0θM −

M−1M (I1s − S1)

Quality cut-off: θc(M) = I0(1−p)M(S1−pR1)+(M−1)(I1s−S1)(1−p)


Model: Results

Result 1: As the market power M of the bank increases, firms with lower

credit quality obtain finance

min

[I0M

θ,

S1 − pR1

1− p

]≥ D1 ≥

I0θM− M − 1

M(I1s − S1)

I0Mθ : Limit set on interest rate by bank’s market power

S1−pR11−p : Limit set by moral hazard

Result 2: The initial interest rate contracted by the lowest quality firm

financed by a bank with market power M is lower than it would be if such

a firm were to be financed by a bank with market power M ′ with M > M ′

Result 3: On average, the relative decline in demanded repayments as the

firm get older is lower when the bank has more market power


Empirical Implications

Use the Herfindahl index as a proxy for competition:

DefineI H < 0.1 as Competitive Credit MarketI H > 0.18 as Concentrated Credit Market

Credit Market Competition and Firm QualityI Prediction: If the quality distribution is the same, more firms and from

lower quality should be asking for credit in more concentrated marketsI Result: Quality of firms in the most competitive CM seem as good as

in the most concentrated CM Table 1

Credit Market Competition and the Availability of FinanceI Young firms in the concentrated CM are more likely to obtain credit

Table 2

I As firms grow older the difference vanishesI Difference is not explain by less borrowing in the concentrated market


Empirical Implications II

An Alternative Measure of Credit AvailabilityI If firms can not borrow from bank → search for more expensive sourcesI Amount of expensive borrow should be a measure of credit rationingI Two instruments: Trade Credit and Days Payable Outstanding (DPO)I Proxy for rationing: Percentage of discounts takenI Firms in the concentrated CM appear to be less constrained Table 3

I Robustness: regress % of discounts taken against measures of thefirm’s investemnt opportunity, cash flow, strength of lendingrelationships and CM competition

F Positive Effect: Age, Size, Profits, length of relationship, debt from

financial service provider, concentrationF Negative Effect: Corporation, Number of institutions from which

borrows, Metropolitan Statistical Area Table 4

Summary:I Young firms appear to be less constrained in concentrated CMI Firms in the concentrated credit market appear to be less constrained


Empirical Implications III

Cost of Capital Differences in Competitive and ConcentratedMarkets

I Model suggests:F Higher interest rate in competitive markets at the beginningF Lower interest rate in competitive markets as firm ageF More rapidly decline in interest rate in competitive markets

I Table 6

I Robustness: Regress loan rate on log of firm’s age and control forobservable firm and loan characteristics Table 7

F Firms in concentrated market start with lower interest rate.F Interest rates drop as the firm grows olderF The drop is faster in the competitive marketF Figure 2


Credit Market Competition and Firm Quality

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Credit Market Competition and the Availability of Finance

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Alternative Measure of Credit Availability

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Alternative Measure of Credit Availability II

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Costs of Capital Differences

Young firms pay higher interest rates than old ones

Decline is faster in the more competitive market

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The Effect of Credit Market Competition on Lending ...mkredler/ReadGr/AllubOnPetersenRajan95.pdf · A monopolistic creditor ... CM competition limits the ability to share surplus