RDP 9206: Loan Rate Stickiness: Theory and Evidence 1. Introduction

The last decade has seen the re-emergence of interest in issues dealing with the operation of the financial system. This interest has taken both theoretical and empirical work in two broad directions. The first is an exploration of the links between the financial system and aggregate economic activity^[1]. The second direction focuses on more microeconomic issues. Questions such as why do banks exist, how do they set interest rates and what type of principal-agent problems arise in banking have received considerable attention. This paper has its roots in this second area of research. It examines possible reasons, other than collusive behaviour, for the stickiness of banks' loan rates and uses data on the various lending rates of Australian banks to examine the degree and causes of interest rate stickiness^[2].

Price stickiness has long played a central role in macroeconomics. Paralleling the recent renewed interest in financial markets, there has been renewed interest in the causes of price stickiness. Many theories of slow or incomplete price adjustment in goods and labour markets have been suggested. These include theories based on market structure and lack of competition, on implicit risk-sharing contracts, on costs of changing prices and on consumer switching costs^[3]. While, in the banking sector, price stickiness has often been attributed to a lack of competition (see Hannan and Liang (1991)), many of the explanations advanced to explain price stickiness in goods markets are also applicable to financial markets. For example, Hannan and Berger (1991) use the menu cost model of Rotemberg and Saloner (1987) to explain stickiness in bank deposit rates, while Klemperer (1987) suggests that his model of switching costs could also be used for the same purpose. Fried and Howitt (1980) apply the Azariadis (1976) model of implicit insurance contracts in labour markets to explain loan rate stickiness as a method of assuring risk averse lenders of a relatively constant interest rate. A number of explanations of stickiness in lending rates which take into account the special nature of a loan cpntract have also been advanced. Amongst these explanations, perhaps the most well known is the work of Stiglitz and Weiss (1981) which shows that in an equilibrium characterised by credit rationing, the loan rate may not move when other interest rates move.

In this paper we pay particular attention to four explanations of the stickiness of loan rates charged by banks. These explanations are based on credit rationing, switching costs, risk sharing and consumer irrationality.

The empirical work in this paper examines the behaviour of different lending rates in response to changes in various measures of the banks' cost of funds. In contrast to the bulk of studies on interest rate stickiness, we examine the behaviour of a number of different Australian lending rates. These include the rates on housing loans, secured and unsecured personal loans, business loans and credit cards. For purposes of comparison, we also examine the behaviour of a number of interest rates in other countries.

The various rates that we consider apply to loans with different risk characteristics and different switching costs. An examination of the various lending rate responses to changes in the cost of funds thus allows tentative inferences to be drawn as to the source of any observed rigidity. Our results do not, however, discriminate sharply between different hypotheses. Such discrimination is made difficult by the inability to observe the information costs involved in bank lending.

The remainder of the paper is structured as follows. Section 2 presents the four theories of loan rate stickiness mentioned above. Section 3 then discusses the data, our empirical strategy and our results. We find a considerable degree of price stickiness in all lending rates except for the indicator rates for business loans. We interpret our results as providing some support for the switching cost explanation although we cannot rule out other explanations. Finally, Section 4 concludes and summarises.

Footnotes

See Gertler (1988) for a summary of this work. [1]

For a recent empirical evaluation of market structure in the Australian banking industry, see Fahrer and Rohling (1992). Testing three types of market structure, they find that the hypotheses of both perfect competition and perfect collusion can be rejected, but that Cournot oligopoly cannot be rejected by the data. [2]

See Blanchard and Fischer (1989) for a summary of various theories of price rigdi ty, [3]