Bank Loan Pricing in an Imperfectly Competitive Bank Market

Abstract

This paper presents a theoretical model of bank loan pricing in an imperfectly competitive interbank market under Basel capital requirements. It is based on the relevant work by Ruthenberg and Landskroner (2008) who develop a model along the same lines, although our model incorporates more realistic assumptions such as a non-zero Recovery Rate on loans and a securities portfolio to match capital and reserves. Under the loan-pricing equation suggested, quoted loan rates depend on monopoly power, elasticity of demand for loans, risk premiums (in the interbank market and for individual borrowers) and the market required Return-On-Equity weighted by Basel risk-weighted capital ratios. The borrower’s Probability of Survival enters as a compounding factor for the whole loan rate.

Keywords: bank loans, imperfect competition, interbank rate, risk premium, bank loan rate