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Bank Reputation, Bank Commitment, and the Effects of Competition in Credit Markets

Article (PDF Available) inReview of Financial Studies 13(3):781-812 · July 2000
DOI: 10.1093/rfs/13.3.781 · Source: RePEc
Serdar Dinc at Rutgers, The State University of New Jersey
  • 19.74
  • Rutgers, The State University of New Jersey
Abstract
This article discusses the effects of credit market competition on a bank's incentive to keep its commitment to lend to a borrower when the borrower's credit quality deteriorates. It is shown that, unlike in the borrower's commitment problem to keep borrowing from the same bank in “good” times, the increased competition may strengthen a bank's incentive to keep its commitment. Banks offer loans with commitment to the highest quality borrowers but, when faced with competition from bond markets, they also give these loans to lower quality borrowers. An increase in the number of banks has a non-monotonic effect; new banks reinforce a bank's incentive only if there are a small number of banks.
Bank Reputation, Bank Commitment,
and the Effects of Competition in
Credit Markets
I. Serdar Din¸c
University of Michigan
This article discusses the effects of credit market competition on a bank’s incentive to
keep its commitment to lend to a borrower when the borrower’s credit quality deterio-
rates. It is shown that, unlike in the borrower’s commitment problem to keep borrowing
from the same bank in “good” times, the increased competition may strengthen a bank’s
incentive to keep its commitment. Banks offer loans with commitment to the highest
quality borrowers but, when faced with competition from bond markets, they also give
these loans to lower quality borrowers. An increase in the number of banks has a non-
monotonic effect; new banks reinforce a bank’s incentive only if there are small number
of banks.
The inability to contract across all contingencies may result in inefficien-
cies in bank lending. The borrower may not undertake efficient investments
if future refinancing is difficult to obtain in the case of temporary distress.
The lender may not provide funds when the borrower is in distress if the
surplus cannot be shared in the long run.
1
This problem can be mitigated,
however, if the lender and the borrower interact repeatedly. For example,
a bank’s concern to maintain a “good” reputation can induce the bank to
keep its commitment to a costly action [see, e.g., Sharpe (1990), Boot,
Greenbaum, and Thakor (1993), Aoki (1994), Chemmanur and Fulghieri
(1994)]. Indeed, the use of bank reputation as an enforcement mechanism
seems to be widespread.
2
This article is based on a chapter in my Ph.D. dissertation. I am grateful to my committee members—Masahiko
Aoki (main advisor), Douglas Bernheim, Avner Greif, and Paul Pfleiderer—for their invaluable guidance. I also
thank Marco Da Rin, Thomas Hellmann, Kevin Murdock, two anonymous referees, the editor, and seminar
participants at numerous institutions for many helpful comments, and Kathryn Clark and Alexandra Haugh
for editorial help. Address correspondence to I. Serdar Din¸c, Department of Finance, University of Michigan
Business School, 701 Tappan St., Ann Arbor, MI 48109-1234, or e-mail: dincs@umich.edu.
1
Although this is an old problem in economics, Mayer (1988) appears to be the first one to discuss it in the
context of finance. See also Hellwig (1991).
2
Duca and Vanhoose (1990) observe that 80% of commercial loans in the United States are made via loan
commitments that the bank has little or no legal obligation to honor. Boot, Greenbaum, and Thakor (1993)
give examples of bank off-the-balance-sheet activities in which bank reputation plays an important role. Aoki
(1994) discusses the importance of bank reputation in inducing a main bank to rescue its distressed borrowers
in Japan.
The Review of Financial Studies Fall 2000 Vol. 13, No. 3, pp. 781–812
© 2000 The Society for Financial Studies
The Review of Financial Studies/v13n32000
Although the importance of reputation in banking is well studied, our
understanding about the effects of credit market competition on a bank repu-
tation mechanism is limited because much of the existing theory assumes the
bank’s return to be independent from the competition it faces. This leaves
many important questions unanswered: Is a reputation mechanism sustainable
with increased competition? Does it matter if the competition comes mainly
from security markets instead of other banks? To what type of borrower does
a bank offer to lend with commitment? How do the characteristics of these
borrowers change with increased competition?
This article examines how credit market competition changes the effec-
tiveness of bank reputation in enforcing a bank’s commitment. It provides a
theory in which the bank’s incentive to keep its commitment is derived as a
function of (1) its reputation, (2) the number of competing banks and their
reputation, and (3) the competition from bond markets. The type of borrower
that is offered bank commitments is also determined.
A bank can provide arm’s length lending in which the bank makes no
commitment to future refinancing if the borrower experiences financial dis-
tress. A bank with a good reputation can also provide relationship lending
in which the bank promises refinancing, which may be costly to the bank
in the short term. The difference between the future (discounted) expected
return from arm’s length lending and that of relationship lending determines
the bank’s incentive to incur any short-term cost to keep its commitment and
maintain a good reputation.
An increase in credit market competition may decrease the bank’s return
from relationship lending. Whether this decrease weakens the bank’s incen-
tive to maintain a good reputation depends, however, on how the same
increase in competition affects the bank’s return from arm’s length lend-
ing, which does not require a good reputation. In particular, if the increased
competition decreases the bank’s return from arm’s length lending more than
it decreases its return from relationship lending, the additional competition
strengthens the bank’s incentive to maintain a good reputation. Thus it can
be misleading to conclude that any increase in credit market competition that
decreases the bank’s return from relationship lending is necessarily harm-
ful for the effectiveness of a reputation mechanism. This article shows that
whether the additional competition is beneficial or harmful depends both on
the source of competition and the level of competition.
To understand why the source of an increase in credit market competition
can be important, consider the case in which borrowers that could previ-
ously borrow only from banks gain access to bond markets. Bonds are a
closer substitute for arm’s length lending than relationship lending. Hence
when a bank faces competition from bond markets, its profit from arm’s
length loans decreases more than its profit from relationship lending. This
asymmetric effect increases the bank’s incentive to keep its commitment in
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Bank Reputation, Bank Commitment, and the Effects of Competition
relationship lending (i.e., maintaining a good reputation), although its profits
from it decrease.
The level of competition is also important because an increase in the num-
ber of banks may have a nonmonotonic effect on the feasibility of a reputa-
tion mechanism. If the banks have large market power, they already earn so
much from arm’s length loans that any additional return they can capture does
not justify the cost of a commitment. On the other hand, reputational rents
ultimately decrease with the number of banks that have a good reputation,
which makes the reputation mechanism most effective with an intermediate
number of banks.
This article also makes predictions about the type of borrower to which
a bank offers relationship lending. The bank offers relationship lending to
borrowers with the highest credit quality because only these borrowers have a
sufficiently high net return from their projects to cover the commitment costs.
The bank offers to give only arm’s length loans to medium-quality borrowers,
and it refuses to lend to the lowest level altogether. Whether a borrower is
offered relationship lending or not also depends on the competition the bank
faces. In particular, since the funds raised in the bond market are a closer
substitute for arm’s length loans, the competition from bond markets forces
the bank to lower the threshold above which it offers relationship lending.
This article sheds light on several trends in banking. One is the deregu-
lation of capital markets that is taking place in many countries, including
Japan and the European Union. The impact of deregulation is reinforced
by another trend, the closer integration of financial markets. An important
concern is how the resulting increase in competition will affect relation-
ship lending. Indeed, as argued by Allen and Gale (1998), the importance
of relationship lending—or lack thereof—is an important difference among
financial systems. This article shows that not only do the bank’s incentives
to invest in these lending relationships survive the increased competition, but
they may even be strengthened, provided that borrowers continue to value
these relationships.
3
Disintermediation is a trend in which borrowers increasingly use security
markets to raise funds instead of borrowing directly from banks. An interest-
ing aspect of this trend is that banks continue to play a role even if they do
not provide the funds, because the securities the borrowers issue are often
“backed up” by loan commitments from banks. How the capital market com-
petition affects the bank’s incentive to monitor the borrower, and ultimately
honor its commitment, is an open question. This article shows that capital
market competition may actually enhance a bank’s incentive to honor its
commitment, although the competition decreases its profit from doing so.
3
See Aoki and Din¸c (2000) for a discussion of the Japanese case.
783
The Review of Financial Studies/v13n32000
Finally, bank mergers, some of them of unprecedented magnitude, are an
important trend worldwide. An important issue is whether a bank will con-
tinue to honor its commitments if the increase in its market power following
a merger makes its borrowers reluctant to “punish” that bank by deserting
it if it does not keep its promises. This article demonstrates that the bor-
rowers’ easier access to capital markets decreases the minimum number of
banks necessary to sustain a reputation mechanism and hence mitigates the
potential negative effects of mergers.
Petersen and Rajan (1995) study the borrower’s commitment problem to
share future surplus with the bank; inability to commit may prevent the bor-
rower from obtaining funds for a project. The market power of a bank in
the credit market mitigates this commitment problem by allowing the bank
to capture in relationship lending some of the borrower’s future surplus.
Petersen and Rajan show that an increase in the credit market competition,
which decreases the bank’s market power and weakens the bank’s incentive
to offer funds at the beginning, has a negative effect on relationship lending.
Alternatively, this article studies the bank’s commitment problem to lend to a
borrower in temporary distress after financing that borrower in “good” times.
In the model, the bank can offer relationship lending or arm’s length lending
to a borrower based on the borrower’s credit quality. Unlike the borrower’s
commitment problem in Petersen and Rajan, an increase in the credit market
competition may help mitigate the bank’s commitment problem in relation-
ship lending. This article demonstrates that the effect of any increase in credit
market competition is not uniform, but depends both on the source and the
level of competition. It also provides empirically testable predictions about
the type of borrowers that are offered relationship lending and how their
characteristics change with an increase in credit market competition.
Boot and Thakor (1999) also study the viability of relationship lending
under increasing competition. They show that initially the expected amount
of relationship lending increases, but it decreases as competition escalates. In
addition, they find that capital market competition causes the bank to increase
its relationship lending relative to its arm’s length lending. Although these
results are similar, different empirical implications about the type of borrower
that is offered relationship lending are obtained in this article.
4
This article
predicts that (1) higher-quality borrowers are offered loans with commitment,
but the threshold of creditworthiness above which a loan with commitment is
offered decreases with competition, and (2) bond markets decrease the mini-
mum number of banks necessary to sustain a reputation mechanism. Boot and
4
Among the major differences that lead to different predictions are (1) entry restrictions in banking and the
bank’s credit screening ability are the sources of bank rents in this article (in addition to any reputational
rents) while it is the access to cheaper core deposits in Boot and Thakor (1999); (2) the bank’s return from
relationship lending depends only on the number of other banks in Boot and Thakor, while it also depends
on their reputation and the borrower’s access to bond markets in this article. The second difference leads to
more precise predictions about the effects of increasing competition in this article.
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Bank Reputation, Bank Commitment, and the Effects of Competition
Thakor offer opposite predictions for the first and have no counterpart for the
second, as the existence of relationship lending (but not its importance rela-
tive to arm’s length lending) is independent of the borrowers’ access to bond
markets in their article. The predictions in this article appear to be consistent
with the existing empirical literature, as discussed in the conclusion.
The rest of the article is organized as follows. Section 1 presents the model.
Section 2 provides a preliminary analysis, which shows that the assumption
of decreasing market power with increasing competition has, by itself, only
ambiguous implications. Accordingly, the model is extended in Section 3
to derive a bank’s market power as a function of the number of competing
banks. The effects of an increase in the credit market competition are exam-
ined in Section 4, where both an increase in the number of banks as well
as the borrowers’ access to bond markets are considered. Section 5 discusses
the robustness of the findings. The final section concludes.
1. The Model
Entrepreneur: Consider a risk-neutral entrepreneur who has a two-subperiod
project.
5
The project requires one unit of capital at date 0 and returns are
obtained at date 2. At date 1, the project can be at one of three states: suc-
cess, distress, or failure with probability p
S
, p
D
, and p
F
, respectively. In suc-
cess, the project returns a cash flow R
S
and nontransferable control benefits
C
S
to the entrepreneur. These benefits can be prestige, perks, or rents to the
entrepreneur from an accumulated knowledge about the project as well as the
expected return from being able to undertake future projects upon the success-
ful completion of the current one. In failure, both cash and nontransferable
returns are zero. In distress, the returns are the same as in failure, unless
the entrepreneur further invests one unit of capital at date 1. In that case,
cash and nontransferable returns are R
D
and C
D
. This additional investment
will be referred to as rescue investment. Any such investment in other states
is wasted. The project has no liquidation value and there is no discounting
between subperiods. The following parametric assumptions are made.
Assumption 1.
(i) R
D
< 1
(ii) R
D
+ C
D
> 1
(iii) p
S
R
S
p
D
(1 R
D
)>1
(iv) p
S
R
S
+ p
D
R
D
< 2
Assumption 1(i) implies that investing an additional unit in a distressed
project has a negative net present value (NPV) if only cash returns are con-
sidered. Assumption 1(ii) states that a distressed project has positive NPV
5
This game will be the stage game when its infinitely repeated version is studied. The term subperiod is used
now since the term period in repeated games is traditionally reserved for the time during which the stage
game takes place.
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if the nontransferable returns to the entrepreneur are also included. Assump-
tion 1(iii) implies that the project has a positive expected NPV in cash returns
at date 0, including the (cash) losses from further investing at the distressed
state. Assumption 1(iv) states that the borrower cannot borrow rescue funds
at date 0 to use them in case of distress at date 1.
Lenders: The entrepreneur has no funds, but can borrow from a type of
institutional lender, or, simply, a “bank.” To model the market power of
banks in the credit market, it is assumed that the banks have a riskless lending
opportunity at date 0 that gives them a net return M>0 at date 2. The model
will be extended in Section 3 to determine endogenously a bank’s market
power and its lending strategy as a function of the number of competing
banks. The bondholders will be introduced in Section 4.
Information and contracts: The uncertainty about the project state is
revealed at date 1 and, while it can be publicly observed, it cannot be ver-
ified in courts. The cash returns are verifiable at date 2 without cost. This
article focuses on debt contracts. One way to justify this focus is that equity
contracts may be too risky for the lenders.
The time line of this two-subperiod game is summarized as follows:
Date 0: The bank determines the interest factor (one plus the interest
rate). The entrepreneur borrows funds and undertakes the project.
Date 1: The project state is revealed and publicly observed. In the dis-
tressed state, the bank decides whether to offer a rescue credit.
If provided with funds, the entrepreneur undertakes the rescue
investment.
Date 2: The returns are obtained; payments are made.
2. Preliminary Analysis
2.1 One-shot lending
In a subgame perfect equilibrium, the bank must be provided with incentives
to offer rescue financing in the distressed state. Since the project state is not
verifiable, these incentives cannot be provided by court-enforced contractual
clauses that oblige the bank to give a rescue loan in a distressed state but
not in others. The bank therefore provides rescue financing only if the cash
returns in a distressed state are sufficient to pay back the loan. By Assump-
tion 1(i), they are not; hence the bank does not provide rescue financing in
a distressed state in a subgame perfect equilibrium.
Proposition 1. The following strategy profile is the subgame perfect equi-
librium: At t = 0, the bank lends one unit with the interest factor (one plus
the interest rate) b, where:
b =
1 + M
p
S
(1)
At t = 1, if the project is in distress, the bank does not rescue the entrepreneur.
786
Bank Reputation, Bank Commitment, and the Effects of Competition
It is important to consider whether an equity contract could induce the
bank to provide rescue funds. If the equity contract allows the bank to cap-
ture some of the entrepreneur’s control benefits, the bank might indeed have
an incentive to rescue the entrepreneur. The control benefits may, however,
include future returns to the entrepreneur, who may not be forced to dis-
tribute dividends [Hart and Moore (1989, 1994)].
6
Furthermore, the bank is
unlikely to capture any managerial perks.
More complicated contracts, even if they are feasible,
7
are not likely to
improve efficiency either, as long as the project state at date 1 and the
entrepreneur’s control benefits remain unverifiable in court. However, it is
useful to examine why the contracts that give the entrepreneur the option to
borrow one unit at date 1 are not feasible. The entrepreneur would use that
option not only in distress, but also in failure. Thus any such option would
also have to give the bank the discretion to refuse the loan in the failure state
but to impose costs to the bank if it also refused to lend in the distressed
state. Since the project state is not verifiable, such discretion and costs cannot
be contracted upon; hence that discretion must be provided within a different
institutional arrangement. The following subsection analyzes one of the most
common of such institutions, namely, bank reputation.
2.2 Bank commitment in repeated lending
Banks are not one-time, anonymous participants in the credit market; they
engage in repeated lending with many borrowers. This repeated, nonanony-
mous nature of bank lending might make a reputation mechanism feasi-
ble to enforce bank commitments.
8
Accordingly, an infinitely repeated game
framework is used to analyze whether a bank’s commitment to rescue an
entrepreneur in distress can be enforced by bank reputation. In the repeated
games terminology, the investment game of the previous section becomes the
stage game of the repeated game. The length of the stage game is referred to
as a period. A common discount factor δ<1 is assumed between the peri-
ods, with no discounting within a period. The entrepreneurs exit the economy
6
The entrepreneurs can provide themselves with large salaries instead of distributing dividends or can do
business with companies that are self-owned; these possibilities also rule out preferred shares as a way to
mitigate the bank commitment problem.
7
See Hart (1995) for why such contracts may not be feasible.
8
Reflections of a bank’s concern for its reputation are often seen in the popular press. Yoh Kurosawa, the
deputy president of Industrial Bank of Japan, explains their incentive as the main bank to rescue a distressed
borrower by stating that “[o]ur reputation is that we never let a client go bust,” [Economist (October 17,
1987)]. Indeed, banks may go to great lengths to keep a good reputation. After real estate prices in Japan
suddenly and drastically declined in 1991, the banks continued to support even the companies that had clearly
gambled. The banks’ motives were interpreted by one analyst with Nikko Research Center Ltd. as “[b]anks
have been supporting deadlocked debtors to save face as main banks, but current public opinion is that
banks are better off disposing of non-working assets for their health, [Nikkei Weekly (August 2, 1993)]. The
difference between the main bank loans that include a rescue commitment and the bank loans without such
commitment also seems to be clearly recognized. When Azabu Tatenomo Co., a real estate company that
faced large debts after investing heavily during the 1980s, rejected the Mitsui Bank’s conditions for a rescue,
Mitsui Bank declared that “[they] will have to change from being the main bank to a legalistic relationship
of creditor and debtor, [Japan Economic Newswire (March 11, 1993)].
787
The Review of Financial Studies/v13n32000
after one period, while the banks live infinitely long. This assumption allows
for a focus on the bank’s commitment problem by abstracting from the pos-
sibility of the entrepreneur’s commitment to borrow from the same bank in
the future. It is also assumed that the history of the economy is common
knowledge and that a bank, for simplicity, only lends to one entrepreneur in
a given period.
Consider now a reputation mechanism with the following features: At
t = 0 in a given period the bank commits to a rescue if the project is in
distress at t = 1 (in the same period). If it does not rescue the entrepreneur
in the distressed state, it loses its good reputation and no other entrepreneur
will ever take a loan with a rescue commitment from that bank again. Since
an entrepreneur can borrow from another bank, this threat is credible. By not
rescuing, the bank saves the rescue costs but loses future return from lending
with a rescue commitment. If the present value of such losses is greater than
the rescue cost, this reputation mechanism can enforce a bank’s commitment.
Some additional terminology and notation will facilitate the formal state-
ment of a repeated game equilibrium. The term relationship lending is used
interchangeably with loans with commitment, and arm’s length lending with
loans without commitment. Let M
G
, with M M
G
, denote the market power
of a bank with a good reputation when the bank lends with the promise of
rescue. Although M
G
depends on the number of competing banks with the
same reputation, as shown in the next section, it is taken as given in this
section in order to focus on the equilibrium features. To avoid triviality, it
is assumed that the entrepreneur prefers to borrow with a bank commitment,
that is,
Assumption 2. p
D
C
D
M
G
M.
Proposition 2. Consider the following strategy profile of the repeated game:
At t = 0 in a given period the entrepreneur borrows from a bank that has
never shirked from rescuing. At t = 1, if the project is in distress, the bank
rescues the entrepreneur. If it fails to do so, future entrepreneurs do not
borrow from that bank; if an entrepreneur borrows, the bank does not rescue
the entrepreneur. If
M
G
M>p
D
(1 R
D
) (2)
then there exists a
¯
δ, where
¯
δ =
1 R
D
M
G
M + (1 p
D
)(1 R
D
)
(3)
such that for δ
¯
δ this strategy profile is a subgame perfect equilibrium of
the repeated game.
788
Bank Reputation, Bank Commitment, and the Effects of Competition
Proof. Let W
G
) and W(δ) be the present value of a bank’s net return
on the equilibrium path and on the punishment path while being punished,
respectively. Then
W
G
) =
M
G
p
D
(1 R
D
)
1 δ
and W(δ) =
M
1 δ
. (4)
It is only necessary to verify that a one-shot deviation on the equilibrium path
is not beneficial. The bank’s incentive constraint to rescue an entrepreneur in
distress is given by
R
D
1 + δW
G
) δW (δ). (5)
Equation (2) is a necessary and sufficient condition for Equation (5) to be
satisfied for some δ. Equation (3) then follows. The interest factor b
G
is then
given by
b
G
=
1 + M
G
p
S
. (6)
On the punishment path, the entrepreneur has no incentive to borrow from
the deviant bank because a loan can be obtained with a commitment from
another bank. Finally, the deviant bank has no incentive to rescue a distressed
borrower, as no future entrepreneur will believe its commitment once it has
shirked. Q.E.D.
The bank does not rescue every entrepreneur who is unable to meet debt
obligations; the genuine failures are not provided with credit. This feature
of the equilibrium is similar to the material adverse change clause that is
observed in virtually all loan commitment contracts [Shockley and Thakor
(1997)]. This clause gives the bank the right not to honor its commitment.
If the public state is not perfectly and publicly observed, the use of this
clause may have reputational costs to the bank. However, the banks and the
entrepreneurs may still prefer loan commitment contracts to other feasible
contracts [Boot, Greenbaum, and Thakor (1993)].
The assumption about the perfect public observability of the distressed
state facilitates the analysis, but the equilibrium is robust to that assumption.
Even if the distressed state cannot be distinguished from the failure state by
outsiders, a bank rescue can still be observed because it is likely to include a
significant restructuring in the firm with possible asset sales. If a bank denies
the occurrence of the distressed state to avoid rescue costs, its rescues—
and all the observable activities associated with it—will have a different
frequency from the rescues by a bank that keeps its commitment. A finding
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by Fudenberg, Levine, and Maskin (1994) implies that this difference is
sufficient for a similar repeated game equilibrium to exist.
9
Proposition 2 gives the conditions for a reputation equilibrium. As is
typical in repeated games, this is not the only equilibrium. The stage game
equilibrium given in Proposition 1 is also an equilibrium when it is repeated
every period. In this article I abstract away from how a reputational equilib-
rium is selected or how the banks build their reputation. The focus here is
on the feasibility of building a reputation and on the effects of competition
once banks have built their reputation.
Equations (2) and (3) hint at the nontrivial impact of bank competition on
the reputation mechanism. Equation (3) indicates that whether a reputation
mechanism is feasible or not does not depend on the bank’s market power
per se, but on the difference between the bank’s market power when it has a
good reputation and its power without such a reputation. In particular, even
if an increase in competition decreases the bank’s market power, it may be
easier to sustain a reputation mechanism if this difference increases. This
gives the following corollary.
Corollary 1.
¯
δ decreases—and the reputation mechanism becomes easier to
sustain—as M
G
M increases. In particular,
¯
δ decreases if an increase in
competition decreases both and M
G
and M but increases M
G
M.
It may seem that Equation (2) can be easily satisfied if the entrepreneurs
voluntarily leave more of the project return to the bank whenever the bank’s
market power is not enough to induce it to keep its commitment. The
entrepreneur can, after all, increase the bank’s return by purchasing addi-
tional services from the bank and/or by concentrating all their borrowing
needs on one bank to give information rents. Although these practices are
indeed observed in reality, they will have only a limited effect for at least
two reasons. First, the asymmetric information problems between a borrower
and a lender limit the effectiveness of such practices; borrowers with the
highest probability of requiring a rescue will be the most willing to offer
such concessions to a bank. Second, what the entrepreneur can voluntarily
leave to the bank is limited by the total cash return from the project. This
is likely to be a problem when a bank’s market power in lending without a
commitment is already large.
Thus the mere assumption that a bank’s market power decreases with an
increase in competition has ambiguous implications. For a theory with more
9
Technically speaking, suppose the project state is observable only by the bank but not by the public. There
are two pure actions the bank can take: rescue and not rescue. The probability distributions induced by these
actions on the publicly observable outcome (date 2 returns) are linearly independent of each other. Hence the
action profile that prescribes rescue when the entrepreneur is in distress but not otherwise has individual full
rank [Definition 5.1 in Fudenberg, Levine, and Maskin (1994, p. 1014)]. Consequently, Condition 2 (p. 1021)
is trivially satisfied and the Nash-threat folk theorem 6.1 (p. 1022) follows. Unfortunately this theorem only
gives the existence of an equilibrium; it does not give the equilibrium strategy profile.
790
Bank Reputation, Bank Commitment, and the Effects of Competition
powerful implications, a bank’s market power and its lending strategy must
instead be determined endogenously as a function of the competition the
bank faces.
3. Equilibrium with Bank Competition
To determine a bank’s market power and its lending strategy endogenously
as a function of the number of its competitors, the model is extended to
incorporate one of the main characteristics of banks as institutional lenders:
information processing capabilities that mitigate the asymmetric information
problem in creditor-debtor transactions.
10
This article focuses on the credit
screening activities of banks before they offer a loan. The analysis below
follows Din¸c (1997), showing that the credit screening abilities of banks are
enough to give them market power in the credit market when there are entry
restrictions in banking.
Consider a second type of entrepreneur who always fails. These
entrepreneurs are referred to as “bad” and those described earlier as “good.”
An entrepreneur is of the good type with probability λ. The entrepreneur’s
type is her private information at date 0. Each bank screens the entrepreneur
by obtaining a costless signal at date 0. These signals are correlated with
the entrepreneur’s type but are subject to errors that are independent across
banks. In particular, it is assumed that bank i obtains the signal x
i
that is
real valued and has full support over [x
, ¯x] for any given type θ of the
entrepreneur. Given the nontransferable nature of the information obtained in
the credit screening, it is assumed that each bank’s signal is its private infor-
mation. The signals are identically and, conditional on the entrepreneur’s type
θ, independently distributed across banks with conditional density function
f(x|θ). The standard assumption that f(x|θ) satisfies the monotone likeli-
hood ratio property (MLRP) is adopted, that is,
Assumption 3 (MLRP). f(x|θ = G)/f (x|θ = B) increases in x.
Therefore if a bank obtains the signal x, its probability estimate µ(x) that
the entrepreneur is of the good type is given by
Pr = G|x) =
λf (x |θ = G)
λf (x |θ = G) + (1 λ)f (x|θ = B)
µ(x). (7)
Notice that µ(x) is increasing in x by Assumption 3. It is assumed that
lending and rescuing an entrepreneur is a positive-NPV project for the bank
10
For theoretical arguments see, for example, Leland and Pyle (1977), Campbell and Kracaw (1980), Diamond
(1984, 1991), and Fama (1985). For empirical evidence, see, for example, James (1987), Lummer and
McConnell (1989), Hoshi, Kashyap, and Scharfstein (1990), James and Wier (1990), Petersen and Rajan
(1994), Berger and Udell (1995).
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The Review of Financial Studies/v13n32000
if its signal indicates sufficiently good credit quality, that is,
Assumption 4. µ( ¯x)(p
S
R
S
p
D
(1 R
D
)) 1 > 0.
At date 0, the entrepreneur asks each bank the interest rate it demands for a
unit loan. Each bank quotes its interest rate without observing the quotations
of other banks; the entrepreneur selects the bank that offers the lowest rate.
The bank has the option to refuse to lend. The analysis that follows focuses
on the symmetric equilibrium that banks with the same reputation have the
same strategies.
11
3.1 One-shot lending
The equilibrium in the one-shot lending game has the same features as stated
earlier, except the determination of the interest rate. A bank with a low esti-
mate µ(x)—or with a low signal x—refuses to lend; hence there is a thresh-
old of x below which the bank does not lend. However, the calculation of
this threshold and of the interest rate the bank quotes when it lends is not
immediate due to the “winner’s curse.” Technically this bank competition
model is a sealed-bid, first-price, common-value auction; thus the insights
developed in other contexts are valid [see Milgrom and Weber (1982)].
To gain intuition about the winner’s curse and a bank’s strategy in deter-
mining the interest rate quoted at equilibrium, suppose that the rate the bank
quotes decreases with µ(x)—hence with its signal x (this is indeed the case
in equilibrium). Consequently a bank lends only if it quotes the lowest inter-
est rate. In a symmetric equilibrium, this implies that the bank’s loan offer is
taken if it has the highest estimate µ(x), or equivalently, the highest signal
x, among all the banks. Therefore the bank that gets to lend is the most
optimistic bank about the entrepreneur’s prospects as its signal provides an
upper bound on the signals of all other banks. Consequently, a bank chooses
its quote to maximize its expected profit based on not only its own signal,
but also the fact that winning the competition gives an upper bound on the
other banks’ signals.
Proposition 3 (Arms’s length lending). The following strategy profile is the
(symmetric) subgame perfect equilibrium of the (stage) game: At t = 0, the
interest factor demanded by a bank is given by the decreasing function b
N
(x)
for x x
N
—derived in the appendix—with no loan offered for x<x
N
,
where x
N
decreases with λ.
12
The entrepreneur borrows from the bank that
11
This article shares the same bank competition model with Rajan (1992) with the important exception of
the information structure. In Rajan, one bank (the insider) knows everything—and more—the other banks
(outsiders) know about the borrower. In this model, all the banks are symmetric at the time of competition
in the sense that (i) none of them has access to what the other banks know about the borrower; and (ii) all
the banks have the same credit screening technology. The information structure of this model is closer to
Broecker (1990) and Thakor (1996).
12
N mnemonic for no commitment.
792
Bank Reputation, Bank Commitment, and the Effects of Competition
demands the smallest interest factor. If the loan is not obtained, the project
is not undertaken. At t = 1, if the project is in distress, no bank rescues
the entrepreneur. The expected profit of each bank at date 0 is positive; it
decreases with the number of banks and converges to zero as the number of
banks goes to infinity. There is no subgame perfect equilibrium in which the
bank rescues the entrepreneur in distress.
Proof. See the appendix.
An important feature of this model is that it derives both a bank’s market
power and its lending strategy with respect to the number of banks. Although
the economic intuition behind the positive profits of the banks is the same as
those of the bidders in mineral rights auctions [Milgrom and Weber (1982)],
it is worth discussing how the banks with the same screening technology and
no inside information make positive profits. Each bank bases its strategy on
its signal about the entrepreneur; consequently the probability of winning the
competition for a given bank, and thus the bank’s return, depends on other
banks’ signals as well. However, each bank’s signal is its private information.
The private nature of these signals gives the bank a rent to private informa-
tion. As the bank always has the option of not offering a loan when it expects
losses, this information rent leads to positive expected profits when the entry
into banking is restricted.
13,14
3.2 Bank commitment in repeated lending
The equilibrium strategy profile presented in Proposition 2 is maintained
when the bank commits to rescuing in the distressed state, but the lending
strategy of the banks is modified. To allow a bank to offer loans both with a
rescue commitment and without, it is assumed that whether a loan carries a
rescue commitment or not is publicly observed.
15
The lending strategy of banks that commit to rescue is similar to their strat-
egy when they do not commit except for one important difference. A bank’s
13
For a more technical intuition about why banks earn positive profits, suppose that they do not. If the bidding
function b
N
leaves the bank with zero expected profits before obtaining signal x, then the bank must also
make zero profits for any signal x (otherwise, for the range of x where the bank makes a negative profit, the
bank could do better by not bidding). Suppose for some x>x
N
the bank bids slightly higher than b
N
(x).
The probability that it wins the bidding then decreases, but it would make a positive profit when it wins.
Therefore the bank could do better by deviating from b
N
, which contradicts the fact that b
N
is an equilibrium
bidding function.
14
The different information structure in this article gives a very different result from the one in Rajan (1992),
who adopts the same competition model. In Rajan, the insider bank not only has better information about
the entrepreneur than other banks, but it also knows what the others know about the entrepreneur. Since the
information of each outside bank is not its private information, each makes zero profit and their number has
no effect for the inside bank’s rent.
15
An important lending practice in which a bank’s reputation enforces its rescue commitment is the main bank
lending in Japan. Although this commitment is implicit, it is publicly known which bank acts as a main bank
for a given company [see Aoki, Patrick, and Sheard (1994)]. The observability of the bank commitment is, of
course, not an issue for loan commitment contracts in the United States.
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The Review of Financial Studies/v13n32000
lending strategy now has a three-tiered structure with respect to its signal
instead of two. At the top range, it offers a loan with commitment, while
its loan offer does not carry a commitment at the middle range. The bank
refuses to lend at the lower range. For intuition, suppose that the entrepreneur
always prefers to be rescued even if all the cash return has to be left to the
bank in the success state. If the bank lends to a good type with a rescue
commitment for a given interest factor b, its expected net return at date 0 is
p
S
b p
D
(1 R
D
) 1, (8)
which is less than what it would be without a rescue commitment. The inter-
est factor the bank can demand is naturally bounded from above by the
available cash return, so the threshold below which the bank does not lend
with a commitment is higher than the threshold for a loan without a com-
mitment. This three-tiered lending strategy is consistent with the empirical
evidence on loan commitment contracts in the United States [see Avery and
Berger (1991), Qi and Shockley (1995)].
However, the lending strategies of banks on the punishment path (i.e.,
the deviant bank cannot lend with a commitment while all the others can)
are very complicated to derive explicitly for generic parameters because the
symmetry among the banks is lost.
16
To simplify the derivation, the private
benefits an entrepreneur obtains from refinancing in the distressed state are
assumed to be sufficiently high. Thus even if a bank offers relationship lend-
ing in exchange for all the cash return in the success state, its offer cannot
be undercut by a bank that offers only an arm’s length loan.
Assumption 5. p
D
C
D
p
S
R
S
1.
Proposition 4 (Relationship lending). Consider the following modifications
in the strategy profile given in Proposition 2 (b
C
and x
C
are derived in the
appendix).
17
Equilibrium path: At t = 0 in a given period, the bank lending strategies
are given by
b
C
(x) and the bank commits to rescue, for x x
C
b
N
(x) and the bank does not commit to rescue, for x
N
x<x
C
no loan, for x<x
N
where b
N
and x
N
are as given in Proposition 3.
The entrepreneur considers an offer with a rescue commitment only if the
bank has never shirked from rescuing. At t = 1, if the project is in distress
16
The derivation of equilibrium strategies in a sealed-bid, first-price, common-value auction with n bidders who
have asymmetric payoff functions is an open question in auction theory. Thus reputation building by banks is
not modeled explicitly here, as reputation building inherently involves asymmetries among banks.
17
C mnemonic for commitment.
794
Bank Reputation, Bank Commitment, and the Effects of Competition
and the loan carries a rescue commitment, the bank that lends at t = 0
rescues the entrepreneur.
Punishment path: The deviant bank offers only loans without a commitment
while all the other banks adopt a similar three-tiered lending strategy as on
the equilibrium path. (The exact lending strategies are given in the appendix.)
There exists ¯n 2 such that for n ≥¯n a subgame perfect (repeated game)
equilibrium with features given earlier exists for δ
¯
δ(n). For all n< ¯n no
subgame perfect equilibrium with these features exists for any δ<1.
Proof. See the appendix.
In three-tiered lending strategies, banks offer a rescue commitment—and
incur rescue costs in distress—only if a borrower is a good credit risk.
Accordingly the bank’s profit shows a qualitative difference between x
C
and
x
N
. Although the reason for the existence of a middle range [x
N
,x
C
) in bank
strategies is the rescue cost, x
C
is not the threshold below which the bank
makes expected loses if it lends with a commitment. Instead, x
C
is the level
at which the bank is indifferent between lending with a commitment for all of
the cash return in the success state and lending without a commitment at the
(lower) equilibrium bid. Since the bank makes positive expected profits from
lending without a commitment when x>x
N
, it also makes positive profits
if it lends with a commitment at x = x
C
. However, the bank is indifferent at
x = x
N
to lending at all, for the bank’s profit is zero at x = x
N
.
A deviant bank can still make positive profits on the punishment path due
to information rents discussed earlier. However, its expected profit is less
than the profit of a bank with a good reputation on the equilibrium path.
This difference, which induces the bank to keep a good reputation for high
δ, can be interpreted as rents to reputation.
An important aspect of the equilibrium is that it exists only if there is a suf-
ficient number of competing banks. In fact, the reputation mechanism cannot
be sustained with a monopolist bank and it may take more than a duopoly
to sustain it. For example, if the monopolist bank judges an entrepreneur
creditworthy, it sets the interest rate such that it receives all the cash return
in the success state. Since it already receives all it can, it has no incentive to
commit to a rescue and incur costs; therefore lending without a commitment
is more profitable.
Corollary 2. The monopolist bank has no incentive to commit to a rescue.
By the same reasoning, the condition ¯n 2 may hold as a strict inequal-
ity.
18
The profit from arm’s length lending decreases to zero as the number of
banks increases; after a threshold, relationship lending becomes more prof-
itable if the entrepreneur is sufficiently creditworthy.
18
By making the left-hand side of Assumption 4 arbitrarily small, ¯n can be made arbitrarily large.
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4. The Effects of Competition
4.1 Entry of new banks
An important issue is whether new banks can provide relationship lending.
Depending on δ, there exist multiple equilibria that differ as to whether new
banks can provide relationship lending; the repeated game theory is silent
in equilibrium selection. Since reputation building by banks is not modeled
explicitly,
19
the entry of banks is studied under two different assumptions.
4.1.1 Entry of new banks that can commit to rescue. It is helpful to start
with a study of the limit behavior when the number of banks that can provide
relationship lending goes to infinity. At the limit, the minimum discount
factor that sustains a reputation mechanism converges to 1. Intuitively, as
the number of banks with a good reputation increases, the rent to a good
reputation converges to zero; hence it becomes more difficult to sustain the
reputation mechanism.
Proposition 5. lim
n→∞
¯
δ(n) = 1.
Proof. See the appendix.
This finding is consistent with the view that commitment is difficult to
sustain by a reputation mechanism with fierce competition. Notice, however,
that this is a limit result. It does not imply that the reputation mechanism
becomes monotonically more difficult as the number of banks increases. In
fact, Propositions 4 and 5 together establish the lack of any such monotonic-
ity. They imply that additional competition may be beneficial to sustain a
reputation mechanism when the number of banks is small; hence an inter-
mediate number of banks is optimal.
Corollary 3. It is easiest to sustain a reputation mechanism with an inter-
mediate number of banks, that is,
¯
δ(n) is minimized at n
where 1 <n
< .
4.1.2 Entry of new banks that cannot commit to rescue. At the other
extreme, the entry of banks that cannot commit affects directly the compe-
tition for arm’s length loans. This is sufficient, however, for the banks that
can provide relationship lending to change their equilibrium behavior. As the
market for arm’s length loans becomes more competitive with new banks, the
return from such loans decreases. Thus relationship lending becomes more
profitable for the banks that give these loans relative to arm’s length lending.
19
The model can be modified where rescues require certain banking skills, for example, intense monitoring, but
the banks have heterogeneous skills and their skills are their private information. The capable banks would
build a reputation by gradually revealing their type. The analysis of bank competition in that context is very
complicated, however, because the symmetry among banks is lost (see note 16). A natural conjecture would
be that whenever the competition enhances the reputation mechanism in the model, it would also facilitate
reputation building of capable banks.
796
Bank Reputation, Bank Commitment, and the Effects of Competition
These banks decrease the minimum credit quality they demand to extend
relationship lending and the share of relationship lending increases in their
loan portfolios. Even though new entrants only provide arm’s length lend-
ing, relationship lending becomes easier to obtain from banks with a good
reputation.
The entry of banks that cannot commit also extends the range of param-
eters where the reputation mechanism can be sustainable. Recall that if a
bank with a good reputation does not keep its commitment, it tarnishes its
reputation and it can then provide only arm’s length loans. The entry of new
banks decreases the return from such loans, and, hence, it decreases the return
from not keeping a commitment. This enhances a bank’s incentive to keep its
commitment and the reputation mechanism becomes easier to sustain with
the entry of banks that cannot provide relationship lending. Thus an increase
in competition increases the effectiveness of a reputation mechanism.
Proposition 6. The entry of banks that cannot commit makes the reputa-
tion mechanism easier to sustain and lowers the minimum credit quality
demanded for relationship lending, that is,
¯
δ(n), ¯n, and x
C
decrease with the
number of banks that cannot commit.
Proof. See the appendix.
4.2 Competition from security markets
Banks face increasing competition from bond and commercial paper markets,
since the funds raised in these markets are close—but not perfect—substitutes
for bank loans. The effect of this competition is likely to be different on
different types of loans. In fact, one of the conditions for a reputation mech-
anism to be effective is the identifiability of the lender that makes a com-
mitment. The anonymous and diffuse nature of security markets does not
allow the reputation mechanism to be an enforcement mechanism for a secu-
rity holder’s commitment [Chemmanur and Fulghieri (1994)]. Funds raised
through these markets are a closer substitute for arm’s length loans than for
relationship loans. This difference makes the competition from security mar-
kets similar to the competition from the entry of banks that cannot commit;
it decreases the return to a deviant bank more than it does to a bank that
keeps its commitment.
The model is modified to incorporate bond issues by entrepreneurs. At
date 0, the entrepreneur decides on the fraction to be raised by bond issues.
This may be different for different types of loans. Banks make offers for
loans. To minimize the signaling issues and focus on bank reputation, it is
assumed that bondholders observe only whether the loan is obtained and
the type of loan—arm’s length or relationship—but not the default premium
on loans. Bondholders do not have any credit screening capabilities, unlike
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The Review of Financial Studies/v13n32000
banks, so they make zero expected profits. Although the debt priority struc-
ture is not essential for the results, it is assumed for concreteness that the
bonds have seniority over bank loans.
20
Proposition 7 (Relationship lending with bond markets). There is a rela-
tionship lending equilibrium at which the entrepreneurs raise a fraction of
their needs by issuing bonds; the bank provides the rest through a loan with
a commitment to rescue. The borrower’s access to bond markets makes the
relationship lending easier to sustain and lowers the minimum credit quality
demanded for loans with commitment, that is,
¯
δ(n), ¯n, and x
C
decrease with
the borrower’s access to bond markets.
Proof. See the appendix.
This finding indicates that the idea that bond markets are not compati-
ble with banking relationships is not necessarily correct as far as the bank’s
incentives to commit to a rescue are concerned. First, it shows that raising
funds through the bond market and maintaining a lending relationship are not
mutually exclusive for a borrower. The borrower raises some funds by issu-
ing bonds while also obtaining relationship lending. Second, the borrower’s
access to a bond market does not limit the bank’s ability to commit to a
costly rescue, but, in fact, it enhances its incentives to do so. This is true,
although the bank’s return from relationship lending decreases with compe-
tition from the bond market. Relationship lending becomes easier to sustain
and the necessary number of banks for an effective reputation mechanism
declines. Finally, competition from bond markets forces banks to offer rela-
tionship lending to borrowers with lower credit quality.
5. Robustness
5.1 Bank competition
While this article adopts a specific bank competition model to analyze bank
strategies and returns, the finding that banks make positive profits under
restricted entry depends not on the specific game form, but on the private
information a bank obtains by credit screening. This suggests that the find-
ing about the effects of competition on bank reputation is valid for differ-
ent bank competition models, including when the entrepreneur approaches
banks sequentially, as long as a bank’s screening results are not observed—
or inferred—by other banks before they make their own loan offers [see Din¸c
(1997) for a more detailed discussion].
20
The model can also be modified in such a way that the entrepreneur uses the bank commitment to back up
its obligations to bondholders.
798
Bank Reputation, Bank Commitment, and the Effects of Competition
5.2 Costly screening
Although this article assumes zero screening costs for banks, the results
are robust as long as screening costs are not too large. If a bank incurs a
(fixed) screening cost, the size of the cost determines whether the bank makes
ex ante positive profits. If the screening cost is less than the expected profit,
every bank screens and participates in the bidding; the qualitative results
remain unchanged. If the cost is high with respect to the loan size and the
number of competing banks, each bank plays a mixed strategy in screening
and participating in the bidding. The mixing probability is determined such
that each bank makes zero expected profits. Which case is relevant is, of
course, an empirical question. However, one immediate implication of large
screening costs is that an increase in the number of banks does not change the
(average) number of banks that bid for the loan. It only decreases the prob-
ability with which a bank screens and participates in the bidding process;
the equilibrium (average) interest rate remains constant. Thus the empirical
evidence about the effects of an increase in the number of banks on bank
lending is not consistent with screening costs that are high enough to erase
bank profit.
21
5.3 Bank risk taking
Agency problems between bank managers and shareholders are not a part of
the model. Although this omission is necessary to keep the model tractable,
it has to be kept in mind in determining the overall effects of the changes
in credit market competition. For example, while an increase in competition
may enhance the bank’s incentive to keep its reputation, it may also induce
bank managers to take risks to keep their perks [Gorton and Rosen (1995)].
Indeed, Din¸c (1999) finds that Japanese banks increased their real estate lend-
ing in the 1980s after the capital market deregulation, and that the keiretsu
ties between banks and some of their shareholders provided protection to
bank managers from the discipline of other shareholders. Such risk taking
may affect relationship banking in Japan more substantially than any change
in the bank’s incentive to keep its commitment due to increased competition.
5.4 Long-lived entrepreneurs
In order to focus on the problem of bank commitment, it was assumed that
each entrepreneur exits the economy after one period. If there are long-lived
entrepreneurs, then this affects R
D
, the bank’s return at the end of a rescue.
Such an extension to the model does not change the qualitative results, but
it does raise further issues. One issue is the inside information the bank
would have in the following rounds of lending. In that case, R
D
can include
the information rent to the bank after a rescue. Rajan (1992) shows that
the bank’s rent from this inside information is independent of the number of
21
See, for example, Hannan (1991), Petersen and Rajan (1995), as well as the references cited in Din¸c (1997).
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The Review of Financial Studies/v13n32000
competing banks. Thus the results reported here on the effects of competition
on bank reputation would be the same. Another issue is that repeated lending
allows the entrepreneur to commit to borrowing from the same bank and/or
not to raise more than a certain fraction by issuing bonds. This has the same
effect as increasing R
D
; it facilitates the bank’s commitment. It does not
change the finding about the effects of competition.
With long-lived entrepreneurs, the positive effects of competition may be
offset by the negative effects identified by Petersen and Rajan (1995). Banks
are likely to face this tension as credit markets are deregulated because, while
their ability to capture rents from a borrower in future lending will decrease,
they will have to focus on the type of lending that distinguishes them from
the security markets.
22
6. Conclusion
This article studies the bank’s commitment problem to lend to a borrower
in distress after financing the borrower in good times. It shows that a rep-
utation mechanism may mitigate this problem in a repeated bank lending
setting. The effectiveness of this reputation mechanism depends on the credit
market competition. Unlike the borrower’s commitment problem, an increase
in credit market competition may enhance the bank’s incentive to lend to a
borrower in distress and maintain a good reputation. Whether an increase in
competition is beneficial or not depends on both the source and the level of
competition. For example, bonds are a closer substitute for arm’s length bank
lending (loans without commitment) than for relationship lending (loans with
commitment). Hence the borrower’s access to bond markets decreases the
bank’s return from arm’s length lending more than that of relationship lend-
ing. This enhances the bank’s incentive to keep its commitment and maintain
a good reputation.
The effect of an increase in the number of banks depends on the number of
banks already in the market. An increase in banks may decrease reputational
rents too much to sustain a reputation mechanism if there is already a large
number of banks. On the other hand, if banks have large market power, they
can capture so much of the borrower’s surplus that they do not have incentive
to offer costly commitments. In that case, an increase in the number of banks
is beneficial for the reputation mechanism.
The theory presented has further empirical implications. These include
Entrepreneurs with higher credit quality are more likely to be offered
bank commitments.
22
The comments of Reese Harasawa, a corporate planner at Mitsubishi Bank, made at a time when Japanese
companies drastically increased the amount they raised from security markets after deregulation, seem to
reflect these opposing effects in main bank lending: “Banks are still lenders of last resorts. [However,] banks
used to endure bad times in the hope of better deals later. That idea is changing now.” [Financial Times
(September 23, 1988)].
800
Bank Reputation, Bank Commitment, and the Effects of Competition
The interest rate charged decreases with credit quality.
The average credit quality of the entrepreneurs who are offered relation-
ship lending decreases if the banks face competition from bond markets.
Faced with competition from bond markets, the share of relationship lend-
ing in a bank’s loan portfolio increases.
The minimum number of banks necessary to sustain a reputation mech-
anism decreases with the borrowers’ access to bond markets.
The entry into a banking market by banks that cannot offer relationship
lending has implications similar to those of the competition from bond
markets.
Some of these empirical implications already have support in the empirical
literature. Avery and Berger (1991) observe that the performance of the loans
extended through loan commitments is better than that of noncommitment
loans, implying that borrowers with higher credit quality are offered loan
commitments. Qi and Shockley (1995) show that better quality firms tend
to finance with loan commitments. Shockley and Thakor (1997) find that
interest rates and fees paid on loan commitment contracts decrease with the
borrower’s credit quality.
The available empirical evidence about the effect of bond markets on
bank lending incentives is also consistent with the theoretical predictions
provided in this article. Horiuchi (1994) and Din¸c (1999) observe that large
Japanese banks substantially increased the share of loans made to small and
medium-size companies after the capital market deregulation in the early
1980s. Anderson and Makhija (1999) find that the proportion of bond debt
of Japanese companies in the late 1980s was inversely related to their growth
opportunities, which is consistent with the prediction that bond markets
strengthen a bank’s incentive to keep its commitment not to hold up its
borrowers in relationship banking. Gande, Puri, and Saunders (1999) find
that smaller companies benefited more from the increasing competition in
bond underwriting, which is similar to this article’s prediction that increased
competition induces banks to offer services to lower-rated borrowers than
they previously did.
The theory presented has additional implications for empirical work on the
effects of credit market competition on bank lending. One of the main points
is that the effects of credit market competition are different for different types
of bank lending. Consequently any empirical study on credit market compe-
tition has to be precise about the type of bank lending studied. Such studies
also have to be explicit about the source of the increase in competition, espe-
cially whether this increase is due to better access to security markets or to
the entry of new banks. Finally, the impact of a change in competition may
not be monotonic but may show qualitative differences at different levels.
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Appendix
Proof of Proposition 3. The symmetric equilibrium of the competition game is analyzed with
a more general payoff function for banks than implied in Proposition 3, for this competition
game will be the main building block for the analysis to come. Let X = (X
1
,...,X
n
) denote a
vector, the components of which are real-valued signals of the banks, and Y
1
be the maximum
signal among X
1
= (X
2
,...,X
n
). Let f
Y
1
and F
Y
1
denote the density and the distribution
functions of Y
1
and
v(x,y) = E[V(θ)|X
1
= x, Y
1
= y], (A1)
respectively, where V(θ) is the identity function that takes the value 1 if θ = G, and 0 oth-
erwise. Notice that v(x, y) depends on the number of banks n through y. Milgrom and Weber
(1982) show that, if the density f(x
i
|θ) has MLRP for all i, then variables θ,X
1
,...,X
n
are
affiliated,
23
and that v(x, y) increases in both x and y.
Lemma A1. Let the bank’s payoff function π be given by
π(b) = V )(p
S
bL κ) L, (A2)
where L is the loan size, κ 0 is any possible cost incurred in lending to a good type, and b is
the interest factor (interest rate plus one). Let T denote the maximum cash return the bank can
obtain. The equilibrium bidding strategies in bank competition are then given by
b
(x) =
x
x
L
v(α, α + L
v(α, α)p
S
L
dM(α|x) for x x
0
(A3)
where M(α|x) = exp
x
α
v(s,s)f
Y
1
(s|s)
H(s,s)
ds
with H(x, s) =
s
x
v(x, α)f
Y
1
|x) ,
x
L
= sup
x
x
0
x
v(α, α)κ + L
v(α, α)p
S
L
dM(α|x) T
and
x
0
= inf
x
{+(T ; x) 0}.
The bank does not offer a loan for x<x
0
. The bank’s expected profit is positive and decreasing
in n.
Proof. The symmetric equilibrium (b
,...,b
) is studied, and, without loss of generality, the
bidding strategy of bidder 1 is examined. The analysis follows Milgrom and Weber (1982).
The necessary conditions are derived for a symmetric equilibrium by assuming that b
is a
decreasing function of x. A bidding function that satisfies these necessary conditions is then
found and verified that it is indeed an equilibrium strategy if all the other banks bid according
to that strategy.
23
Recall that two random variables X and Y are affiliated if f (x, y)f (x
,y
) f(x
, y)f (x, y
) for any x
<x
and y
<y.
802
Bank Reputation, Bank Commitment, and the Effects of Competition
If all other banks bid according to b
, bank 1’s return at Equation (A.2) given its signal
becomes
+(b; b
1
,x) = E
(V )(p
S
bL κ) L)1
{b
(Y
1
)>b}
|X
1
= x
= E
E
(V )(p
S
bL κ) L)1
{b
(Y
1
)>b}
|X
1
,Y
1
|X
1
= x
= E
(v(X
1
,Y
1
)(p
S
bL κ) L)1
{b
(Y
1
)>b}
|X
1
= x
=
b
∗−1
(b)
x
(v(x, α)(p
S
bL κ) L)f
Y
1
|x)dα. (A4)
Twoofthenecessary conditions for the equilibrium are
b
(x) T, for all x (A5)
+(b
; b
1
,x) 0, for all x. (A6)
Equations (5) and (6) imply that the bank does not offer a loan for x<x
0
, where
x
0
= inf
x
{+(T ; b
1
,x) 0}. (A7)
Differentiating Equation (A4) with respect to b and using the inverse function theorem,
+
b
(b;b
1
,x) =
1
b
(b
∗−1
(b))

v(x,b
∗−1
(b))(p
S
bL κ)L
f
Y
1
(b
∗−1
(b)|x)
+
b
∗−1
(b)
x
v(x,α)p
S
Lf
Y
1
|x)dα. (A8)
Setting +
b
(b; b
1
,x) = 0 and arranging terms gives the linear differential equation:
b
(x) =

v(x,x)(p
S
b
(x)L κ) L
f
Y
1
(x|x)
x
x
v(x, α)p
S
Lf
Y
1
|x)dα
, for x x
0
. (A9)
This first-order linear differential equation is a necessary condition. Equations (A5) and (A6)
give the boundary condition for Equation (A9):
b
(x
0
) =
T
L
. (A10)
The solution [Equation (A3)] to the differential equation [Equation (A9)] with the boundary
condition [Equation (A10)] gives the bidding strategies in the symmetric equilibrium. Finally,
notice that M(α|x), regarded as a probability distribution on (x
,x) is stochastically increasing
in x, that is, M(α|x) decreases in x. Hence b
(x) is (strictly) decreasing in x.
Verification of b
(x): The change of variable
dM(α|x) = M(α|x)
v(α, α)f
Y
1
|α)
H (α, α)
gives
b
(x) =
(v(x, x + L)
p
S
L
f
Y
1
(x|x)
H(x, x)
+
x
x
L
v(α, α)κ + L
p
S
L
M(α|x)
v(x,x)f
Y
1
(x|x)
H(x, x)
f
Y
1
|α)
H (α, α)
.
Equation (A9) then follows from Equation (A3).
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The Review of Financial Studies/v13n32000
Sufficiency: To show that b
is a best response when all the other players play b
,itis
sufficient to consider only the bids in the range of b
.Forb
(z) to be an optimal bid when
X
1
= z, it is sufficient for +
b
(b
(x); z) to be nonnegative for x>zand nonpositive for x<z.
From Equation (A8),
+
b
(b
(x); z) =
1
b
(x)
(v(z, x)(p
S
bL κ) L)f
Y
1
(x|z)
+
x
x
v(z, α)p
S
Lf
Y
1
|z) dα
=
1
b
(x)
(v(z, x)(p
S
bL κ) L)
v(z, x)p
S
L
+
x
x
v(z, α)f
Y
1
|z) dα
v(z, x)f
Y
1
(x|z)
. (A11)
The right-hand side of Equation (A11) is, of course, zero for z = x. The following working
lemma will be used to show {+
b
(b
(x); z) +
b
(b
(x); x)}=sgn{x z}.
Lemma A2. (
x
x
v(z, α)f
Y
1
|z)dα)/v(z, x)f
Y
1
(x|z) is decreasing in z.
Proof. The affiliation property implies that
v(z, α)f
Y
1
|z)v(z
,x)f
Y
1
(x|z
) v(z
)f
Y
1
|z
)v(z, x)f
Y
1
(x|z)
or
v(z, α)f
Y
1
|z)
v(z, x)f
Y
1
(x|z)
v(z
)f
Y
1
|z
)
v(z
,x)f
Y
1
(x|z
)
. (A12)
Integrating both sides of Equation (A12) with respect to α gives the desired result. Q.E.D.
Note that
sgn
v(z, x)(p
S
b
(x)L κ) L
v(z, x)p
S
L
v(x,x)(p
S
b
(x)L κ) L
v(x,x)p
S
L
= sgn{z x}. (A13)
As b
(x) < 0, it follows from Equation (A13) and Lemma A2 that
sgn
+
b
(b
(x); z) +
b
(b
(x); x)
= sgn{x z}. (A14)
Positive profits: For x>x
0
,
+(b
(x); x) > +(b
(x
0
); x)
>+(b
(x
0
); x
0
)
= 0,
where the first inequality follows from the equilibrium property while the second follows from
Equation (A4) and the fact that v(x, y) increases with x.
24
Hence the bank’s expected profit
before it obtains its signal is given by E
θ
[E
X
[+(b
(x); x)|θ ]] > 0.
24
The strict inequality for all x>x
0
follows from the full support assumption for bank signals. Without
that assumptions, the inequalities hold strictly only for some x>x
0
. However, the qualitative results are
unaffected.
804
Bank Reputation, Bank Commitment, and the Effects of Competition
Profits decreasing with n: Note that
v(x, α)f
Y
1
|x) =
f
X
1
Y
1
(x, α|θ = G) Pr = G)
f
X
1
Y
1
(x, α)
f
X
1
Y
1
(x, α)
f(x)
=
f
X
1
Y
1
(x, α|θ = G) Pr = G)
f(x)
.
Therefore Equation (A4) becomes
+(b
(x); x) =
F
X
1
Y
1
(x, x|θ = G) Pr = G)
f(x)
p
S
b
F
F
Y
1
(x|x). (A15)
Note that
F
X
1
Y
1
(x, x|θ = G) = [F(x|θ = G)]
n
,
F
Y
1
(x|x) =
[F(x|θ = G)]
n1
Pr = G) + [F(x|θ = B)]
n1
Pr = B)
f(x)
.
By MLRP F(x|θ = B)>F(x|θ = G). Thus
∂n
+(b
(x); x) < +(b
(x); x) ln[F(x|θ = G)]
< 0. (A16)
This concludes the proof of Lemma A1. Q.E.D.
With L = 1, κ = 0, and T = R
S
in Lemma A1, the bidding function b
N
and the threshold
level x
N
in one-shot lending follow. The rest of the equilibrium is as given in Proposition 1.
Q.E.D.
Proof of Proposition 4. As in Proposition 3, only the bidding strategies will be stated and
verified; the rest follows from Proposition 2. Let +
N
(·) and +
C
(·) be the bank’s profit function,
as given in Equation (A4) with κ = 0 and κ = p
D
(1 R
D
), respectively. Suppose
+
C
(R; x) +
N
(b
N
(x); x) for some x< ¯x. (A17)
Let
x
C
inf
x
{+
C
(R; x) +
N
(b
N
(x); x)}. (A18)
Let b
N
(x) be as in Proposition 3 and b
C
(x) be the bidding function given in Lemma A1 with
κ = p
D
(1 R
D
), T = R
S
, and x
0
= x
C
.
Punishment path: If a bank does not keep its rescue commitment, future entrepreneurs do
not borrow a loan with a rescue commitment from that bank. Lending strategies of the deviant
bank are
b
N
(x
C
) and the bank does not commit to rescue, for x x
C
b
N
(x) and the bank does not commit to rescue, for x
N
x<x
C
no loan, for x<x
N
.
Lending strategies of other banks are
b
CP
(x) and the bank commits to rescue, for x x
CP
b
N
(x) and the bank does not commit to rescue, for x
N
x<x
CP
no loan, for x<x
N
.
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The Review of Financial Studies/v13n32000
Let +
(n)
(·) and b
(n)
(·) be the bank’s profit function and the equilibrium bidding function when
the number of banks is n. Let
x
CP
inf
x
+
(n1)
C
(R; x) +
(n)
N
b
(n)
N
(x); x
. (A19)
b
CP
(x) is then the bidding strategy b
(n1)
(x) with κ = p
D
(1 R
D
) and x
0
= x
CP
in Lemma A1.
¯
δ(n): Let w
C
and w
P
be the expected profit per period of a bank with a good reputation on
the equilibrium path and of a deviant bank on the punishment path, respectively that is,
w
C
= E
θ
x
C
x
N
+
N
(b
N
(x); x)f (x|θ)dx
+
¯x
x
C
+
C
(b
C
(x); x)f (x|θ)dx
(A20)
and
w
P
= E
θ
x
CP
x
N
+
N
(b
N
(x); x)f (x|θ)dx
+
¯x
x
CP
+
N
(b
N
(x
CP
); x)f (x|θ)dx
. (A21)
Notice that w
C
and w
P
are a function of n. The bank’s incentive constraint to rescue is
R
D
1 +
δ
1 δ
w
C
δ
1 δ
w
P
(A22)
or
δ
1 R
D
w
C
w
P
+ 1 R
D
¯
δ(n) (A23)
¯n: Note that
lim
n→∞
ν(x, α) = 0 for all x<¯x, α x. (A24)
Hence, for sufficiently high n, it follows from Assumptions 4 and 5 that a bank has an incen-
tive to offer a loan with a commitment—and keep its commitment—if its signal about the
entrepreneur is good enough, that is, there exists ¯n, such that for all n ≥¯n,
µ(x)
p
S
R
S
p
D
(1 R
D
)
1 +
N
(b
N
(x); x) for some x<¯x. (A25)
To see that Equation (A25) is sufficient for the existence of the equilibrium described, suppose
all the banks except one are “forced” to lend without a commitment. Then an equilibrium exists
with one bank offering both types of loans—depending on its signal—while n1 banks offering
only loans without commitment (Proposition 6 gives an equilibrium in which n banks offer both
types of loans and m banks can offer only loans without commitment). The expected return to
the bank that can lend with a commitment is higher than the return of the other banks and those
banks are better off if they are also “allowed” to lend with a commitment. Hence an equilibrium
can be constructed with two banks offering commitment loans, while n 2 banks are still forced
to lend without a commitment, and the rest follows by induction.
Note that a monopolist bank always demands all the cash return from the project; hence
rescuing a distressed borrower only adds a rescue cost without increasing its return. Therefore
¯n 2. Finally, by making the right-hand side of Assumption 4 sufficiently low, ¯n can be made
arbitrarily large. Q.E.D.
806
Bank Reputation, Bank Commitment, and the Effects of Competition
Proof of Proposition 5. Equation (A24) implies that
lim
n→∞
+
C
(b
C
(x); x) = lim
n→∞
+
N
(b
N
(x); x) = 0 for x<¯x.
Hence, from Equations (A20), (A21), and (A23),
lim
n→∞
¯
δ(n) = 1.
Proof of Proposition 6. As before, the symmetric equilibrium of the bank competition where
the same type of banks using the same strategies is considered. The bidding strategies in this
equilibrium are similar to those on the punishment path of bank lending with a rescue commit-
ment, as described in Proposition 4. The banks that can lend with a commitment will be referred
to as established and the other banks as new. Let the number of established banks be n and that
of the new banks be m. The bidding strategies of established banks are
b
(n)
C
(x) and the bank commits to rescue, for x x
CF
b
(n+m)
N
(x) and the bank does not commit to rescue, for x
NF
x<x
CF
no loan, for x<x
NF
where
x
CF
inf
x
+
(n)
C
(R; x) +
(n+m)
N
b
(n+m)
N
(x); x
(A26)
and x
NF
is same as what x
N
would be with n + m banks.
25
The lending strategy of a new bank with an estimate x x
CF
is different from that of the
deviant bank in Proposition 4 because it has to compete with other new banks. Let X, Y, Z be
a (new) bank’s own estimate, the highest estimate among all other new banks and the highest
estimate among all established banks, respectively. Similar to Equation (A1), let
ν
F
(x,y,z)= E
V(θ)|X = x, Y = y,Z = z
. (A27)
Thus the expected profit of a new bank playing the equilibrium bidding strategies b
F
when
x x
CF
is given by, from Equation (A4),
+
F
(b
F
; x) =
x
x
F
(x,x
CF
)p
S
b
F
1)g
Y
|x, x
CF
)dα, (A28)
where
g
Y
|x, x
CF
) = f
Y
|X = x, Z x
CF
). (A29)
b
F
can be obtained from Lemma A1 by substituting g
Y
|x, x
CF
) for f
Y
1
|x) and determining
x
L
such that b
F
(x
CF
) = b
(n+m)
N
(x
CF
). Therefore a new bank’s bidding strategies on the equilib-
rium path are
b
F
(x) and bank does not commit to rescue, for x x
CF
b
(n+m)
N
(x) and bank does not commit to rescue, for x
NF
x<x
CF
no loan, for x<x
NF
.
25
Notice that x
CF
<x
NF
for large m, in which case the established banks compete by offering only loans with
a rescue commitment.
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The Review of Financial Studies/v13n32000
The bidding strategies on the punishment path are the same as those with n 1 established
banks and m + 1 new banks, with the deviant established bank playing the same strategies with
the new banks. Let x
CFP
be the threshold on the punishment path, that is,
x
CFP
inf
x
+
(n1)
C
(R; x) +
(n+m)
N
b
(n+m)
N
(x); x

. (A30)
¯
δ decreases with m: Let w
E
(n, m) and w
N
(n, m) be the expected profit per period of an
established bank and a new bank, respectively, when n established banks and m new banks
compete. The bank’s incentive constraint is analogous to Equation (A23), so
¯
δ decreases with
m,if
w
E
(n, m) w
E
(n, m + 1)<w
N
(n 1,m+ 1) (A31)
w
N
(n 1,m+ 2).
Note that
w
E
(n, m) w
E
(n, m + 1)<w
N
(n, m + 1) w
N
(n, m + 2). (A32)
The proof is then complete if it can be shown that the right-hand side of Equation (A31) is
greater than the right-hand side of Equation (A32) or (∂
2
+
F
(b
F
; x))/∂m∂n > 0 for all x.
From Equation (A15),
+
F
(b
F
; x) =
F
Y
(x,x,x
CF
|θ = G) Pr = G)
f(x,x
CF
)
p
S
b
F
(A33)
G
Y
(x|x, x
CF
).
Lemma A3.
2
∂m∂n
F
Y
(x,x,x
CF
|θ = G) Pr = G)
f(x,x
CF
)
=
ACD
(A + C)
2
ln F(x
CF
|θ = G) ln F(x
CF
|θ = B)
(A34)
and
2
G
Y
(x|x, x
CF
)
∂m∂n
=
AC(D E)
(A + C)
2
ln F(x
CF
|θ = G)
ln F(x
CF
|θ = B)
, (A35)
where
A f(x|θ = G)[F(x
CF
|θ = G)]
n1
Pr = G) (A36)
C f(x|θ = B)[F(x
CF
|θ = B)]
n1
Pr = B) (A37)
D [F(x|θ = G)]
m1
ln F(x|θ = G) (A38)
E [F(x|θ = B)]
m1
ln F(x|θ = B) (A39)
808
Bank Reputation, Bank Commitment, and the Effects of Competition
Proof. Note that
F
Y
(x,x,x
CF
|θ = G) = f(x|θ = G)[F(x|θ = G)]
m1
× [F(x
CF
|θ = G)]
n1
(A40)
f(x,x
CF
) = f(x|θ = G)[F(x
CF
|θ = G)]
n1
Pr = G)
+ f(x|θ = B)[F(x
CF
|θ = B)]
n1
Pr = B) (A41)
G
Y
(x|x, x
CF
) =
F
Y
(x,x,x
CF
|θ = G) Pr = G)
f(x,x
CF
)
+
F
Y
(x,x,x
CF
|θ = B)Pr = B)
f(x,x
CF
)
. (A42)
Hence
∂m
F
Y
(x,x,x
CF
|θ = G) Pr = G)
f(x,x
CF
)
=
AD
A + C
;
2
∂m∂n
F
Y
(x,x,x
CF
|θ = G) Pr = G)
f(x,x
CF
)
=
D
(A + C)
2
A(A + C) ln F(x
CF
|θ = G)
A
A ln F(x
CF
|θ = G) C ln F(x
CF
|θ = B)

, (A43)
and Equation (A34) follows. Similarly,
2
G
Y
(x|x, x
CF
)
∂m∂n
=
ACD
(A + C)
2
ln F(x
CF
|θ = G) ln F(x
CF
|θ = B)
+
ACE
(A + C)
2
ln F(x
CF
|θ = B) ln F(x
CF
|θ = G)
and Equation (A35) follows. Q.E.D.
By Lemma A3,
2
+
F
(b
F
; x)
∂m∂n
=
AC
(A + C)
2
D(p
S
b
F
(x) 1) + E
×
ln F(x
CF
|θ = G) ln F(x
CF
|θ = B)
. (A44)
Notice that D<0 and E<0. From Equation (A6), p
S
b
F
(x) 1 > 0. Finally, MLRP implies
that F(x
CF
|θ = G) < ln F(x
CF
|θ = B); hence ln F(x
CF
|θ = G) ln F(x
CF
|θ = B) < 0. This
establishes that
¯
δ decreases with m.
Finally, +
(n+m)
N
(b
(n+m)
N
(x); x) decreases with m; therefore ¯n and x
CF
decreases with m.
Q.E.D.
Proof of Proposition 7. Although it is not essential for the results, the game has a signaling
component at date 0, when the entrepreneur sets the amount to be raised from the bond market.
Notice, however, that a bad entrepreneur always mimics the good one. Let β denote the amount
the entrepreneur raises by issuing bonds. The loan size L will be explicit in the notation in this
section, for example, b(x, L) and +(b; x, L), respectively. Let Z
1
denote the highest estimate
among banks.
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The Review of Financial Studies/v13n32000
Entrepreneur’s strategy: Raise β = β
N
if a loan without commitment is offered and β = β
C
for a loan with commitment. Collect offers from banks for a loan of size 1 β
N
without
commitment and 1 β
C
with commitment.
Beliefs of banks (before credit screening) and bondholders: If β = β
N
for a loan without
commitment and β = β
C
for a loan with commitment, set Pr = G) = λ. Otherwise Pr =
G) = 0.
Bondholders update their beliefs after observing the loan type as follows: The probability
that the entrepreneur is good is
Pr = G|x
NB
Z
1
<x
CB
) if the loan comes without a
rescue commitment,
Pr = G|x
CB
Z
1
≤¯x) if it comes with a rescue commitment.
Bondholders’ strategy: They do not lend if no bank offers to lend. When they lend, the
repayment D they demand depends on both the type and the amount of the bank loan the
entrepreneur obtains. If the lending bank does not commit to rescue, the repayment D
N
satisfies
Pr = G|x
NB
Z
1
<x
CB
)p
S
D
N
N
) β
N
= 0. (A45)
If the lending bank commits to rescue, the repayment D
C
satisfies
Pr = G|x
CB
Z
1
≤¯x)
p
S
D
C
C
)
+p
D
min{R
D
,D
C
C
)}
β
C
= 0, (A46)
with
x
NB
= inf
x
+
N
(R D
N
N
); x,1 β
N
) 0
and (A47)
x
CB
= inf
x
+
CB
(R D
C
C
); x,1 β
C
)
>+
N
(b
N
(x; 1 β
N
); x,1 β
N
)
, (A48)
where +
CB
is the profit function + in Lemma A1 with κ = p
D
(1 max {0,R
D
D
C
C
)}).In
equilibrium, Equations (A45)–(A48) are satisfied simultaneously.
Access to bond markets decreases
¯
δ
: Suppose β
C
= 0 and β
N
= 1. This case is equivalent to
the entry of infinitely many new banks (m =∞) in Proposition 6. Hence, by continuity, there
exists an equilibrium with 0
C
N
< 1, which decreases
¯
δ. Q.E.D.
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  • ... The importance of bank's reputation in the market, which is associated with higher profitability and sustainability of the bank, have been found to play a role in influencing people's decision when choosing for their banks (Bushman & Wittenberg-Moerman, 2012, Dinç , 2000). The reputation however may be rather subjective as it heavily depend on customers' view and impressions of the bank (Abdul Hamid, 2000 as cited in Almejyesh & Rajha, 2014). ...
  • ... This type of relationship protects the rents of banks and offers an explanation of the increase in bankers' fees. Empirical works [19][20][21]9] show a non-monotonic relationship between the narrow banking relationship and the degree of interbank competition. Indeed, trying to know how banks respond to increased competition, Degryse and Ongena [9] found that when bank branches face stiff local competition, they engage much more in relational lending. ...
  • ... However, the amount of available credit can be reduced by market power. Firm access to financing is greater in a more competitive environment (Berger et al., 1999; Dinc, 2000; Beck et al., 2004; Cetorelli, 2004; Dell'Ariccia and Marquez, 2004). Banks operating in less competitive markets tend to favour old customers over new. ...
  • ... Finally, we control for the average growth rate of province value added in 1991-1998 and for the average of the Herfindahl-Hirschman Index on total bank lending in the province from 1990 to 2006. Dinc (2000) andCarbo-Valverde et al. (2009) under- line the importance of local credit market competition on banks' behavior. Table 4 reports the estimates of the likelihood of credit rationing. ...
  • ... Finally, we control for the average growth rate of province value added in 1991-1998 and for the average of the Her…ndahl- Hirschman Index on total bank lending in the province from 1990 to 2006. Dinc (2000) and Carbo-Valverde et al. (2009) underline the importance of local credit market competition on banks'behavior. ...
  • ... Beyond some level of competition, the protection disappears, and banks will prefer to offer transactional lending. Thus, the relationship between competition and relationship banking should be concave: transactional lending when competition is low, relationship lending when it is medium and transactional lending again when competition is high (Anand and Galetovic, 2006; Dinç, 2000; Yafeh and Yosha, 2001). Although Elsas (2005) and Degryse and Ongena (2007) empirically confirm this nonlinear relationship, they observe a convex, rather than concave, relationship. ...
    ... is negative, and these results (except Soft1) are significant. Thus, we empirically validate Dinç (2000), Anand and Galetovic (2006) and Yafeh and Yosha&apos;s (2001) conclusions—namely, that the relationship between competition and relationship banking appears to be nonlinear and concave. ...
  • ... Likewise, Dell'Arriccia and Marquez (2004) demonstrate that banks may make more loans to informationally opaque borrowers when competition increases to the extent that some banks have better screening ability than others and when uninformed banks cannot free ride on the information gathered by the informed banks. In a similar vein, Dinc (2000) and Anand and Galetovic (2006) show that competition may actually increase a bank's incentive to engage in relationship lending. In contrast, Petersen and Rajan (1995) argue that an increase in competition will reduce relationship lending and lending to informationally opaque borrowers by banks. ...
  • ... Likewise, Dell'Arriccia and Marquez (2004) demonstrate that banks may make more loans to informationally opaque borrowers when competition increases to the extent that some banks have better screening ability than others and when uninformed banks cannot free ride on the information gathered by the informed banks. In a similar vein, Dinc (2000) and Anand and Galetovic (2006) show that competition may actually increase a bank's incentive to engage in relationship lending. In contrast, Petersen and Rajan (1995) argue that an increase in competition will reduce relationship lending and lending to informationally opaque borrowers by banks. ...
  • ... Information asymmetries between debtors and creditors, such as concerning project quality and managerial abilities, are an important challenge in the context of lending. Since the SBCs in our sample are relatively small and usually not monitored by capital markets, the bank may solve or at least mitigate its informational problems by establishing relationships with the SBCs over time (Boot et al. 1993; Dinc 2000). Relationships lower the costs of acquiring information for the bank and increase the dependency of SBCs. ...
  • ... Rajan (1992) points out the possibility that the entrepreneur who expects this sort of hold-up problem reduces his management efforts below the socially optimal level. to renegotiations with firms under a temporary liquidity shortage (Chemmanur and Fulghieri 1994; Dinç 2000). The bank can also provide more effective consultation for its borrower to improve its creditworthiness. ...
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