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Relationship lending and competition: Higher switching cost does not necessarily imply greater relationship benefits

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  • Timo Vesala

    (Bank of Finland)

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    Abstract

    This paper studies relationship lending in a framework where the cost of switching banks measures the degree of banking competition. The relationship lender’s (insider bank’s) informational advantage creates a lock-in effect, which is at its height when the switching cost is infinitesimal. This is because a low switching cost gives rise to a potential adverse selection problem, and outsider banks are thus reluctant to make overly aggressive bids. This effect gradually fades as the magnitude of the switching cost increases, which de facto reduces the insider bank’s profits. However, after a certain threshold in the switching cost, the insider bank’s ‘mark-up’ begins to increase again. Hence, relationship benefits are a non-monotonous (V-shaped) function of the switching cost. The ‘dynamic implication’ of this pattern is that relationship formation should be more common under extreme market structures ie when the cost of switching banks is either very low or sufficiently high. Recent empirical evidence lends support to this prediction.

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    File URL: http://128.118.178.162/eps/fin/papers/0508/0508018.pdf
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    Bibliographic Info

    Paper provided by EconWPA in its series Finance with number 0508018.

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    Length: 30 pages
    Date of creation: 31 Aug 2005
    Date of revision:
    Handle: RePEc:wpa:wuwpfi:0508018

    Note: Type of Document - pdf; pages: 30. Bank of Finland Research Discussion Papers 3/2005
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    Web page: http://128.118.178.162

    Related research

    Keywords: relationship lending; switching cost; banking competition;

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    References

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    1. Boot, Arnoud W. A., 2000. "Relationship Banking: What Do We Know?," Journal of Financial Intermediation, Elsevier, vol. 9(1), pages 7-25, January.
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    Cited by:
    1. Andrea Filippo Presbitero & Alberto Zazzaro, 2009. "Competition and Relationship Lending: Friends or Foes?," Mo.Fi.R. Working Papers 13, Money and Finance Research group (Mo.Fi.R.) - Univ. Politecnica Marche - Dept. Economic and Social Sciences.

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