Quantifying Risk Transformation in Bank Lending

How different is the cost of capital when banks finance a loan compared to the rate required by direct household investors? This paper quantifies this difference by estimating the prices both investors would be willing to pay for an identical set of loan cash flows when markets are segmented and households are subject to idiosyncratic consumption shocks. Using recently developed methods from the private equity literature, I find that banks are willing to pay 70% more than households for the same loans, which equates to a 2% pp lower cost of capital for banks. This difference in cost of capital arises because loans are more "diversifiable" in the bank's portfolio than they are in a household's portfolio, which is subject to idiosyncratic consumption shocks. Additionally, this cost of capital advantage increases when banks lend to riskier firms and possess a larger deposit base. Overall, these findings corroborate classic theories of bank risk-sharing, in which banks invest on behalf of risk-averse households in an effectively more risk-tolerant fashion, providing a lower cost of finance.