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On the profitability and cost of relationship lending

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  • Mitchell Berlin
  • Loretta J. Mester

Abstract

The authors provide some preliminary evidence on the costs and profitability of relationship lending by commercial banks. Drawing on recent research that has identified loan rate smoothing as a significant element in lending relationships between banks and firms, the authors carry out a two-stage procedure. In the first stage, the authors derive bank-specific measures of the extent to which the banks in their sample engage in loan rate smoothing for small business borrowers in response to exogenous shocks to their credit risk. In the second stage, the authors estimate cost and (alternative) profit functions to examine how loan rate smoothing affects a banks' costs and profits. On the whole, the authors' evidence says that loan rate smoothing is associated with lower costs and lower profits. These results do not support the hypothesis that loan rate smoothing arises as part of an optimal long-term contract between a bank and its borrower. However, we do find so me limited support for smoothing as part of an optimal contract for small banks early in our sample period.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 97-3.

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Date of creation: 1997
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Handle: RePEc:fip:fedpwp:97-3

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Keywords: Bank loans;

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  1. Berger, Allen N. & Mester, Loretta J., 1997. "Inside the black box: What explains differences in the efficiencies of financial institutions?," Journal of Banking & Finance, Elsevier, Elsevier, vol. 21(7), pages 895-947, July.
  2. Mitchell A. Petersen & Raghuram G. Rajan, 1994. "The Effect of Credit Market Competition on Lending Relationships," NBER Working Papers 4921, National Bureau of Economic Research, Inc.
  3. Dennis W. Carlton, 1986. "The Rigidity of Prices," NBER Working Papers 1813, National Bureau of Economic Research, Inc.
  4. Joseph P. Hughes & William W. Lang & Loretta J. Mester & Choon-Geol Moon, 1996. "Safety in numbers? Geographic diversification and bank insolvency risk," Proceedings, Federal Reserve Bank of Chicago 504, Federal Reserve Bank of Chicago.
  5. Berger, Allen N & Udell, Gregory F, 1992. "Some Evidence on the Empirical Significance of Credit Rationing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(5), pages 1047-77, October.
  6. Avery, Robert B. & Berger, Allen N., 1991. "Loan commitments and bank risk exposure," Journal of Banking & Finance, Elsevier, Elsevier, vol. 15(1), pages 173-192, February.
  7. Clive D. Fraser, . "Safety in Numbers," Discussion Papers in Public Sector Economics, Department of Economics, University of Leicester 96/9, Department of Economics, University of Leicester.
  8. Ben Bernanke, 1990. "The Federal Funds Rate and the Channels of Monetary Transnission," NBER Working Papers 3487, National Bureau of Economic Research, Inc.
  9. Rotemberg, Julio J & Saloner, Garth, 1987. "The Relative Rigidity of Monopoly Pricing," American Economic Review, American Economic Association, American Economic Association, vol. 77(5), pages 917-26, December.
  10. Mitchell Berlin & Loretta J. Mester, 1997. "Deposits and relationship lending," Working Papers, Federal Reserve Bank of Philadelphia 96-18, Federal Reserve Bank of Philadelphia.
  11. Allen N. Berger & Gregory F. Udell, 1988. "Collateral, loan quality, and bank risk," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 51, Board of Governors of the Federal Reserve System (U.S.).
  12. Hannan, Timothy H., 1991. "Bank commercial loan markets and the role of market structure: evidence from surveys of commercial lending," Journal of Banking & Finance, Elsevier, Elsevier, vol. 15(1), pages 133-149, February.
  13. Fried, Joel & Howitt, Peter, 1980. "Credit Rationing and Implicit Contract Theory," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 12(3), pages 471-87, August.
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