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A Quantitative Theory of Relationship Lending

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Abstract

Banks' loan pricing decisions reflect the fact that borrowers tend to have long-lasting relationships with lenders. Therefore, pricing decisions have an inherently dynamic component: high interest rates may yield higher static profits per loan, but in the long run they erode a banks' customer base and reduce future profitability. We study this tradeoff using a dynamic banking model which embeds lending relationships using deep habits (“customer capital”) and costs of adjusting loan portfolio composition. High customer capital raises the level and decreases the interest rate elasticity of loan demand. When faced with an adverse shock to net worth, banks with high customer capital recapitalize quickly by charging high interest rates and eroding customer capital in the short term, while banks with low customer capital face persistent financial distress. Using Call Report data to measure the franchise value of banks' loan portfolios, we find that this effect has strong implications for how individual banks and the financial sector as a whole recover from shocks.

Suggested Citation

  • Kyle Dempsey & Miguel Faria-e-Castro, 2022. "A Quantitative Theory of Relationship Lending," Working Papers 2022-033, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:94821
    DOI: 10.20955/wp.2022.033
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    1. Javier Bianchi & Saki Bigio, 2022. "Banks, Liquidity Management, and Monetary Policy," Econometrica, Econometric Society, vol. 90(1), pages 391-454, January.
    2. Mark Egan & Ali Hortaçsu & Gregor Matvos, 2017. "Deposit Competition and Financial Fragility: Evidence from the US Banking Sector," American Economic Review, American Economic Association, vol. 107(1), pages 169-216, January.
    3. Tobias Adrian & Nina Boyarchenko, 2012. "Intermediary leverage cycles and financial stability," Staff Reports 567, Federal Reserve Bank of New York, revised 01 Feb 2015.
    4. Rebecca Demsetz & Marc R. Saidenberg & Philip E. Strahan, 1996. "Banks with something to lose: the disciplinary role of franchise value," Economic Policy Review, Federal Reserve Bank of New York, vol. 2(Oct), pages 1-14.
    5. Berlin, Mitchell & Mester, Loretta J., 1998. "On the profitability and cost of relationship lending," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 873-897, August.
    6. Berger, Allen N & Udell, Gregory F, 1995. "Relationship Lending and Lines of Credit in Small Firm Finance," The Journal of Business, University of Chicago Press, vol. 68(3), pages 351-381, July.
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    More about this item

    Keywords

    banks; Customer Capital; relationship lending; interest rates; financial crises;
    All these keywords.

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • G2 - Financial Economics - - Financial Institutions and Services

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