Abstract: Recent work on imperfect competition in lending markets focuses on the interest rate margin, despite the importance of credit rationing in lending. I estimate a structural model of bank competition in interest rates and credit rationing using U.S. mortgage data. I use the estimated model to show how banks optimally trade-off interest rates and credit rationing, and illustrate its policy relevance by examining the magnitude and the form of banks' pass through - to clients - of a cut in funding costs. I find that banks pass through their lower funding cost by not only cutting interest rates but also relaxing credit rationing. There is substantial heterogeneity in the pass through in both margins and this is mainly explained by heterogeneity in two different types of banks' costs: funding cost of originating mortgages and cost of processing applications. Lastly, I quantify the importance of adverse selection and moral hazard in how banks pass through lower funding costs through credit rationing. I find that moral hazard is the more important friction in the U.S. mortgage market, where shutting down moral hazard almost completely erases the pass through in the credit rationing margin.
Work in Progress
Structural Models of Lending Markets: An Industrial Organization Perspective
Why do Banks Securitize Mortgages in the U.S.?
Victor Aguirregabiria: victor.aguirregabiria[at]utoronto.ca
Lu Han: lu.han[at]rotman.utoronto.ca
William Strange: wstrange[at]rotman.utoronto.ca