RDP 9206: Loan Rate Stickiness: Theory and Evidence 4. Summary and Conclusions

This paper examines the degree of price stickiness in the market for bank loans. In the classical world of perfect competition, changes in marpal costs are translated into similar changes in the price of the product. We find that complete pass-through of changes in banks' marginal cost of funds only occurs with the base or reference overdraft rates to large and small business borrowers. For credit cards, personal loans, owner-occupied housing loans and the standard overdraft rate, changes in the banks' marginal cost of funds have not been translated one for one into the contemporaneous lending rates

We discuss four explanations for the stickiness of most of the lending rates. The first explanation relies on the existence of equilibrium credit rationing. In such an equilibrium, banks will be unwilling to increase the lending rate, even when the cost of funds increase, for fear of reducing their expected return. The second explanation relies on the fact that the nature of a bank loan requires the bank to obtain information about each and every customer. The incidence of these information costs falls on the borrower in terms of upfront fees and search costs. These costs reduce the elasticity of demand, giving the bank some market power. Third, the stickiness in the loan rate may be the result of an implicit risk sharing contract between the bank and its customers. Finally, we discuss a form of consumer irrationality in the credit card market.

The results presented in this paper do not allow us to distinguish sharply between these different hypo theses. To do this would require extensive data on the cost of information collection by both banks and customers. Evidence on the notoriously difficult to measure degrees of risk aversion and consumer rationality would also be required. Nevertheless, the results point in particular directions.

We find little support for credit rationing being the explanation of loan rate stickiness. For the housing loan rate, switching costs and risk sharing appear to be important causes of the interest rate stickiness. For the personal loan rate, switching costs are again likely to play a role; however, the failure of the behaviour of the personal loan rate to adjust after deregulation may reflect a lack of competition in this market. Evidence from the standard or most commonly charged rate to small business borrowers suggests some interest rate stickiness.

In summary, there are solid reasons for bank lending rates not moving one-for-one with the banks' marginal cost of funds. Incomplete adjustment of lending rates does not necessarily imply collusive behaviour amongst the banks. The peculiar nature of a banking contract, in which the seller (the bank) acquires information about the buyer (the borrower) but is not able to control either the buyer's actions, or determine her true type, can help explain incomplete pass-through. While little can be done about “switch costs” which arise directly from the costs of information gathering, reducing artificial switch costs is likely to reduce any market power that banks enjoy. This could be done by eliminating mortgage stamp duty and by banks providing more extensive and accessible information about the terms and conditions of various loans.