Monitoring, Moral Hazard, and Market Power: A Model of Bank Lending

28 Pages Posted: 7 Jan 2000

See all articles by Daniel M. Covitz

Daniel M. Covitz

Board of Governors of the Federal Reserve System

Erik Heitfield

Board of Governors of the Federal Reserve System

Date Written: July 15, 1999

Abstract

We model the relationship between market power and both loan interest rates and bank risk without placing strong restrictions on the moral hazard problems between borrowers and banks, and between banks and a government guarantor. Our results suggest that these relationships hinge on intuitive parameterizations of the overlapping moral hazard problems. Surprisingly, for lending markets with a high degree of borrower moral hazard, but limited bank moral hazard, we find that banks with market power charge lower interest rates than competitive banks. We also find that competition makes banking industry risk highly sensitive to macroeconomic fluctuations by making banks more vulnerable to borrower moral hazard. This finding offers an explanation for the dramatic rise and subsequent decline in bank failure rates during the 1980s and 1990s.

JEL Classification: G21, G28, L14, L16

Suggested Citation

Covitz, Daniel M. and Heitfield, Erik, Monitoring, Moral Hazard, and Market Power: A Model of Bank Lending (July 15, 1999). Available at SSRN: https://ssrn.com/abstract=186150 or http://dx.doi.org/10.2139/ssrn.186150

Daniel M. Covitz

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-5267 (Phone)
202-452-5295 (Fax)

Erik Heitfield (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States
202-452-2613 (Phone)

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