Competition and Specialization in Credit Markets

Abstract:     
I analyze the impact of an exogenous increase in credit market competition, brought about by the deregulation of U.S. commercial banking markets, on the degree to which banks differentiate by focusing more of their lending to particular types of borrowers. In more competitive periods post-deregulation, larger and younger banks make more loans backed by real estate, loans arguably characterized as “hard-information” loans. In contrast, smaller and older banks make more unsecured commercial and personal loans, loans arguably characterized as “soft-information” loans. When banks make more real-estate-backed loans, they exhibit larger fractions of defaults yet charge lower average interest rates on these loans, consistent with these banks lowering the costs of lending and expanding credit for this loan category. In contrast, when banks make more unsecured commercial and personal loans, they exhibit lower default rates and charge higher average interest rates on these loans, consistent with these banks becoming better at identifying good quality loans and subsequently charging borrowers in these categories more for this screening ability. Overall, the analysis provides evidence that competition leads to greater specialization in lending amongst banks and indicates how banks may change or innovate to differentiate their lending.

Keywords: Credit market competition, Bank differentiation and specialization, Banking deregulation, Financial innovation

JEL Classifications: G21, L10

Working Paper Series