Research Discussion Papers, Bank of Finland
No 3/2005:
Relationship lending and competition: Higher switching cost does not necessarily imply greater relationship benefits
Timo Vesala
Abstract: This paper studies relationship lending in a framework
where the cost of switching banks measures the degree of banking
competition. The relationship lender’s (insider bank’s) informational
advantage creates a lock-in effect, which is at its height when the
switching cost is infinitesimal. This is because a low switching cost gives
rise to a potential adverse selection problem, and outsider banks are thus
reluctant to make overly aggressive bids. This effect gradually fades as
the magnitude of the switching cost increases, which de facto reduces the
insider bank’s profits. However, after a certain threshold in the switching
cost, the insider bank’s ‘mark-up’ begins to increase again. Hence,
relationship benefits are a non-monotonous (V-shaped) function of the
switching cost. The ‘dynamic implication’ of this pattern is that
relationship formation should be more common under extreme market
structures ie when the cost of switching banks is either very low or
sufficiently high. Recent empirical evidence lends support to this
prediction.
Keywords: relationship lending; switching cost; banking competition; (follow links to similar papers)
JEL-Codes: D43; D82; G21; G24; (follow links to similar papers)
30 pages, February 13, 2005
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