Report

Are there "bank effects" in borrowers' costs of funds? Evidence from a matched sample of borrowers and banks

Abstract: We use a large matched sample of individual loans, borrowers, and banks to investigate whether bank financial health affects terms of lending, holding constant proxies for borrower risk and information costs. In particular, we focus on measuring effects of borrower and bank characteristics on loan interest rates; we also investigate implications of borrower and bank characteristics for indirect measures of credit availability. ; Our principal findings are six. First, even after controlling for proxies for borrower risk and information costs, the cost of borrowing from low-capital banks is higher than the cost of borrowing from well-capitalized banks. Second, this cost difference is traceable to borrowers for which information costs and incentive problems are a piori important. Third, weak bank effects on the cost of funds are higher in periods of aggregate contractions in bank lending. Fourth, estimated weak bank effects remain even after controlling for unobserved heterogeneity in the matching of borrowers and banks. Fifth, weak bank effects are quantitatively important only for high-information-cost borrowers, consistent with models of switching costs in bank-borrower relationships and with the underpinnings of the bank lending channel of monetary policy. Sixth, when we investigate determinants of cash holdings of borrowing firms, we find that firms facing high information costs hold more cash than other firms, all else being equal, and those firms (and only those firms) have higher cash holdings when they are loan customers of weak banks. These results suggest declines in banks' financial health can lead to "precautionary saving" by some firms, a response which may affect their investment spending. ; This evidence sheds light on two sets of questions. First, our estimated effects of bank characteristics on borrowing cost are consistent with models of switching costs for borrowers for whom banking relationships are most valuable. Second, our findings are consistent with switching costs for the borrowers stressed by the "bank lending channel" of monetary policy.

Keywords: Bank loans; Interest rates; Bank capital;

JEL Classification: E44; G21;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Staff Reports

Publication Date: 1999-06-01

Number: 78

Note: For a published version of this report, see R. Glenn Hubbard, Kenneth N. Kuttner and Darius N. Palia, "Are There Bank Effects in Borrowers' Costs of Funds? Evidence from a Matched Sample of Borrowers and Banks," Journal of Business 75, no. 4 (October 2002): 559-81.