Competition and Specialization in Credit Markets

1. Competition and Specialization in Credit Markets Rebecca Zarutskie Duke University 45th Annual Bank Structure Conference Federal Reserve Bank of Chicago May 6, 2009

2. Motivation • Large theoretical, empirical and policy debate about the role of credit market competition on lending. • Conflicting evidence on the role of competition on lending – though some consensus, there are still outstanding questions. • Whether and how banks specialize in reaction to competition is an important component to the debate.

3. Theoretical framework • How may banks specialize, or become better relative to their competitors, in lending? • Two ways • Loan cost reduction • E.g., lower costs of processing loan applications, reduce cost of capital used to make loans by tapping new investor base • Better borrower quality assessment • E.g., banks are able to distinguish individual borrower repayment probabilities relative to the group average • Both types of specialization allow banks to increase their profit margins in these loan markets as well as increase their share of loans in these markets by enabling them to undercut the market interest rates on loans in these markets.

4. Empirical predictions • If a bank specializes more in a particular lending market relative to the other lending markets it serves, we should expect that the bank’s loan portfolio will have a greater share of loans from the market in which it specializes. • If a bank specializes in a lending market by lowering the cost of making loans in that market, we should expect that the average repayment rate on these loans in the bank’s portfolio will be lower, or that the average default rate will be higher. • If a bank specializes by becoming better able to assess borrower quality, we should expect that the average repayment rate on these loans in the bank’s portfolio will be higher, or that the average default rate will be lower.

5. Empirical predictions (II) Larger banks may be able to lower loan costs relative to smaller banks, especially in markets such as lending market H in which borrower quality is accurately observed by all banks. Exploit economies of scale in info technology processing Tap cheaper investor bases through loan re-sales. Smaller banks and banks that have a longer established presence in a lending market may have an advantage in specializing in borrower quality assessment in more opaque lending markets such as lending market S. Smaller banks may be more able to transmit and act on “soft information”, e.g., Stein (2002). Banks that have been in a market for a long time may be better able to observe “soft information”. 5

6. Preview of results Evidence of greater lending specialization after deregulation. Larger banks specialize more in loans backed by real estate - loans arguably characterized as “hard-information” loans. Smaller and older banks specialize more in business loans, especially small business loans, and personal loans – loans arguably characterized as “soft-information loans. 6

7. Preview of results (II) When banks specialize in real-estate-backed loans, they exhibit larger fractions of loan defaults in these loans. Suggests they specialize in these loans by lowering the costs of lending to all borrowers, resulting in an overall expansion of credit in the market for real-estate-backed loans   When banks specialize in business and personal loans, they exhibit lower default rates in these loans. Suggests that they specialize by becoming better at identifying good quality loans, rather than by lowering the overall costs of lending in these markets. Overall, the analysis provides evidence that competition leads to greater specialization amongst lenders and provides evidence on how different lenders become specialists in lending to different kinds of borrowers. 7

8. U.S. banking deregulation • Starting in early 1980s, states began to relax restrictions on bank branching within state borders as well as entry across state borders. • Wave of state-by-state deregulation from 1980 to 1994 • Intrastate branching deregulation • Interstate branching deregulation • Riegle-Neal Interstate Banking and Branching and Efficiency Act of 1994 was a national act which removed final barriers to interstate banking • States had some leeway in when they implemented the acts provisions

9. Data • Call Reports of Income and Conditions (June). • Call Reports contain consolidated income statements and balance sheets for commercial banks maintained electronically by the Chicago Fed. • Call reports contain information by loan category and also report some off-balance sheet items, like derivatives usage and loan sales in later years.

10. Measures of bank specialization • Use loan categories to form concentration measures – HHI and top loan category. • Give a general sense of how concentrated a bank’s loan portfolio is. • Shares of particular loan categories in a bank’s loan portfolio. Basic loan categories are: • RE Loans • C&I Loans (after 1993, small C&I Loans, as well) • Personal Loans • Agricultural Loans • Other Loans

11. Summary statistics

12. Identification of the effect of competition on bank-level specialization Equation (1): Equation (2):

13. Loan category specialization regressions 1976-1994

14. Loan category specialization regressions 1990-2003 14

15. Loan performance regressions Equation (3):

16. Loan performance summary statistics 16

17. Nonperforming loan regressions 17

18. Loan chargeoff regressions 18

19. Results review • Greater specialization after deregulation. • Larger banks specialize more in loans backed by real estate - loans arguably characterized as “hard-information” loans. • Smaller and older banks specialize more in business loans, especially small business loans, and personal loans – loans arguably characterized as “soft-information loans.

20. Results review (II) • When banks specialize in real-estate-backed loans, they exhibit larger fractions of loan defaults in these loans. • Suggests they specialize in these loans by lowering the costs of lending to all borrowers, resulting in an overall expansion of credit in the market for real-estate-backed loans   • When banks specialize in business and personal loans, they exhibit lower default rates in these loans. • Suggests that they specialize by becoming better at identifying good quality loans, rather than by lowering the overall costs of lending in these markets. • Overall, the analysis provides evidence that competition leads to greater specialization amongst lenders and provides evidence on how different lenders become specialists in lending to different kinds of borrowers.