Monitoring, Moral Hazard, and Market Power: A Model of Bank Lending

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.

JEL Classification: G21, G28, L14, L16