Bank Loan Markups and Adverse Selection

Abstract

We analyze market power in local US corporate loan markets. To identify market power, we create a measure of markup that incorporates banks’ internal loan-level risk assessments and is orthogonal to the subsequent performance of loans. In contrast to typical theories of competition, we find that markups are higher in regions in which more banks operate. We provide evidence that this result is driven by asymmetric information across banks, which becomes exacerbated as the number of banks increase. We also provide causal support for the adverse selection channel by showing that markups drop following a shock to large banks’ lending capacities that reduces asymmetric information in local lending markets. Our findings suggest that adverse selection is an important driver of market power in local bank markets and have implications for antitrust policy.

Keywords: bank loans, adverse selection, market power

JEL Classification: G21, G28, L13, L44, G32