Bank Capital, Borrower Power, and Loan Rates

Abstract:     
We test the predictions of several recent theories of how bank capital affects the rates that banks charge their borrowers. Key to all these theories is the notion that the relative bargaining power of a bank and its borrower are critical. We find that banks with low capital are more sensitive to borrower cash flow than are banks with high capital: low-capital banks charge relatively more for borrowers with low cash flow, but offer relatively steeper discounts for borrowers with high cash flow. These effects are robust to controls for business conditions and bank fixed effects. Our results suggest that low bank capital generally toughens bank bargaining power, especially vis-a-vis low-cash-flow borrowers, but weakens bank bargaining power vis-a-vis high-cash-flow borrowers. This is consistent with Diamond and Rajan's (2000) theory of bank capital. By contrast, although earlier work has found that rates for borrowers with access to public debt markets are unaffected by their bank's capital level, once we control for economic conditions, lower bank capital leads to higher spreads for these borrowers as well.

Number of Pages in PDF File: 42

Keywords: Bank loans, bank capital, loan spreads, cash flow, hold-up, information monopolies

JEL Classification: E51, G21, G32

working papers series