Bank Loan Markups and Adverse Selection

Abstract

We analyze the relationship between loan pricing and market concentration in the US corporate loan market by creating a measure of markup using banks’ internal loan risk assessments. Our risk-adjusted measure of markup is orthogonal to the subsequent performance of loans, while a measure that excludes banks’ private risk assessments strongly predicts performance. Consistent with theories in which asymmetric information across banks creates adverse selection which drives markups, we find that markups are higher in less concentrated regions. We provide further support for the adverse selection channel by showing that markups are higher among firms that are more subject to asymmetric information and when firms stay with their existing banks. Finally, higher local markups are associated with lower loan volume and higher levels of collateralization. Our findings suggest that adverse selection drives markups, loan volume and lending standards in local bank markets and have implications for antitrust policy.

Keywords: bank loans, adverse selection, market power

JEL Classification: G21, G28, L13, L44, G32