Banks and Borrower Networks: To Lend or Not to Lend?

22 Pages Posted: 16 Jan 2020

See all articles by Debarati Basu

Debarati Basu

XLRI - Xavier School of Management

Shabana Mitra

Indian Institute of Management, Bangalore

Nishant Kumar Verma

affiliation not provided to SSRN

Date Written: December 30, 2019

Abstract

Banks remain the most important credit source globally despite large-scale financial development. However, banking continues to be plagued by rising costs and information asymmetry. In this context, we show how an additional borrower characteristic, specifically the borrower’s network strength, helps reduce costs by altering the bank’s lending decisions. The literature on borrower network remains largely empirical and borrower-based. We fill this void by being the first to theoretically model the lender’s decision making problem with network effect. We specifically examine how a bank sets the interest rate when networks work as a default risk-mitigating attribute. We find that the interest rate reduces as network strength increases. As constraints set in and borrowing becomes more competitive, banks rely even more on network information to parse out better borrowers. Finally, bank’s substitute monitoring effort with network strength for a more feasible interest rate. This will increase lending, even to borrower’s outside the banks’ purview earlier. Thus, the proposed model can help banks alter their subjective lending decisions to maximize lending and profits. More so, in a data driven world. This has large-scale economic benefits for all stakeholders - banks and other financial institutions, borrowing firms and the economy at large.

Keywords: Finance; Banking; Networks; Soft information; Monitoring; Risk management

JEL Classification: C02, C61, D81, D85, E43, G21, L14

Suggested Citation

Basu, Debarati and Mitra, Shabana and Verma, Nishant Kumar, Banks and Borrower Networks: To Lend or Not to Lend? (December 30, 2019). Available at SSRN: https://ssrn.com/abstract=3511536 or http://dx.doi.org/10.2139/ssrn.3511536

Debarati Basu

XLRI - Xavier School of Management ( email )

C H Area (E), Jamshedpur, Jharkhand
831001
India

HOME PAGE: http://https://acad.xlri.ac.in/facprofile/index.php?701

Shabana Mitra (Contact Author)

Indian Institute of Management, Bangalore ( email )

Bannerghatta Road
Bangalore, Karnataka 560076
India

Nishant Kumar Verma

affiliation not provided to SSRN

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