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Relationship lending and competiiton : higher switching cost does not necessarily imply greater relationship benefits

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  • Vesala, Timo

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. Key words: relationship lending, switching cost, banking competition JEL classification numbers: G21, G24, D82, D43

Suggested Citation

  • Vesala, Timo, 2005. "Relationship lending and competiiton : higher switching cost does not necessarily imply greater relationship benefits," Research Discussion Papers 3/2005, Bank of Finland.
  • Handle: RePEc:bof:bofrdp:2005_003
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    References listed on IDEAS

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    1. Cole, Rebel A., 1998. "The importance of relationships to the availability of credit," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 959-977, August.
    2. J. Miguel Villas-Boas & Udo Schmidt-Mohr, 1999. "Oligopoly with Asymmetric Information: Differentiation in Credit Markets," RAND Journal of Economics, The RAND Corporation, vol. 30(3), pages 375-396, Autumn.
    3. Kim, Moshe & Kliger, Doron & Vale, Bent, 2003. "Estimating switching costs: the case of banking," Journal of Financial Intermediation, Elsevier, vol. 12(1), pages 25-56, January.
    4. Elsas, Ralf, 2005. "Empirical determinants of relationship lending," Journal of Financial Intermediation, Elsevier, vol. 14(1), pages 32-57, January.
    5. Leonard I. Nakamura, 1993. "Loan screening within and outside of customer relationships," Working Papers 93-15, Federal Reserve Bank of Philadelphia, revised 1993.
    6. Franklin Allen & Douglas Gale, 2001. "Comparative Financial Systems: A Survey," Center for Financial Institutions Working Papers 01-15, Wharton School Center for Financial Institutions, University of Pennsylvania.
    7. Greenbaum, Stuart I. & Kanatas, George & Venezia, Itzhak, 1989. "Equilibrium loan pricing under the bank-client relationship," Journal of Banking & Finance, Elsevier, vol. 13(2), pages 221-235, May.
    8. Arnoud W. A. Boot & Anjan V. Thakor, 2000. "Can Relationship Banking Survive Competition?," Journal of Finance, American Finance Association, vol. 55(2), pages 679-713, April.
    9. Krishna, Vijay, 2009. "Auction Theory," Elsevier Monographs, Elsevier, edition 2, number 9780123745071.
    10. Boot, Arnoud W. A., 2000. "Relationship Banking: What Do We Know?," Journal of Financial Intermediation, Elsevier, vol. 9(1), pages 7-25, January.
    11. Broecker, Thorsten, 1990. "Credit-Worthiness Tests and Interbank Competition," Econometrica, Econometric Society, vol. 58(2), pages 429-452, March.
    12. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, vol. 47(4), pages 1367-1400, September.
    13. Franklin Allen & Douglas Gale, 2001. "Comparing Financial Systems," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262511258, February.
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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection

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