Adverse Selection in Corporate Loan Markets

Abstract

When reviewing bank mergers for antitrust, regulators typically argue that higher market concentration leads to higher prices. However, in loan markets, adverse selection can create a negative relationship between market concentration and prices. Using supervisory data, we show that interest rates and banks’ private risk assessments are higher in markets with more banks. We also create a measure of markup that is orthogonal to borrower risk and show that markups are higher in markets with more banks and after repeated borrowing relationships. We provide causal support for the adverse selection channel by using a shock to large banks’ lending capacities.

Keywords: bank loans, adverse selection, market power

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