In the complex world of banking and finance, conventional wisdom dictates that increased competition among suppliers typically drives down prices. However, recent research disrupts this fundamental principle, revealing a startling paradox within the corporate lending market. Cesare Fracassi, an associate professor of finance at Texas McCombs, along with his colleagues Mehdi Beyhaghi from the Federal Reserve Board and Gregory Weitzner of McGill University, unveil findings that challenge the traditional supply-and-demand paradigm for bank loans. Rather than decreasing loan interest rates, a higher concentration of banks in a market actually pushes these rates upwards.
Their extensive analysis encompasses over 20,000 U.S. bank loans above $1 million, spanning the years 2014 to 2019. This expansive dataset includes not only loan terms but also banks’ internal assessments of the likelihood that borrowers might default. Such comprehensive insight offers a rich basis for dissecting market dynamics that were previously misunderstood or underexplored. Contrary to what might be expected, the presence of more lenders doesn’t equate to lower borrowing costs; instead, every increment of six banks within a given county correlates to a 7 basis point increase in interest rates, where a basis point represents one-hundredth of a percent.
This counterintuitive outcome stems from informational asymmetries and risk evaluation challenges intrinsic to banking practices. Banks rely heavily on their ability to screen and assess potential borrowers’ creditworthiness. When multiple institutions compete, the landscape becomes murky. Banks fear that they might be accepting loans the others prudently rejected, due to overlooked or hidden risks associated with the borrower. This concern prompts lenders to increase their interest rates as a buffer against potential defaults, a measure grounded in caution rather than competitive generosity.
Fracassi elucidates this phenomenon by invoking the metaphor of the “winner’s curse,” borrowed from auction theory. In such a setting, the winner is often the bidder who overestimates value and ends up paying more than the item’s true worth. Similarly, a bank that successfully extends a loan that others have declined may be inadvertently bearing excessive risk. As a safeguard, the bank adjusts the price upward to compensate for this uncertainty, which runs counter to traditional expectations that competition leads to cheaper credit.
This elevated risk pricing not only affects loan costs but also shapes the volume and inherent risk associated with bank lending. Evidence reveals that the entry of one additional bank in a market inflates lending volume by an impressive 14%, indicating robust competition for market share. Concurrently, the likelihood of borrower default edges upward by about 1.1 basis points, underscoring the riskier portfolio banks must grapple with in more competitive environments. Such dynamics signal a nuanced balancing act between boosting credit availability and managing default risk.
Additionally, lending relationships impact pricing in less predictable ways. When companies secure multiple loans from the same banking institution, lenders often mark up interest rates by approximately nine basis points. This phenomenon likely arises because banks, having deeper knowledge of repeat borrowers, price in this enhanced information by adjusting rates accordingly. The interplay of repeated interactions and informational depth thus flips the intuitive expectation that familiarity breeds better or cheaper loans.
The implications of this research echo far beyond the academic sphere. Policymakers and regulators, keen to promote competition through measures such as blocking mergers or dividing bank branches, must pause to consider unintended consequences. Fracassi cautions against an uncritical push for more banks in every market, as this could inadvertently harm consumers by stoking higher borrowing costs and increasing systemic risk. Instead, market concentration, often maligned as harmful, might under certain conditions foster more stable, lower-cost credit environments.
For small business owners and entrepreneurs, the findings offer pragmatic counsel in their strategic decisions about where to seek financing. Thriving enterprises confident in their creditworthiness might find more favorable terms in markets with fewer banks, where lenders are less apprehensive about informational blind spots and consequently offer better rates. Conversely, businesses that have faced previous rejections might benefit from operating where multiple banks compete, giving them a chance to “shop around” and find a willing lender despite a riskier profile.
This research punctuates the complex relationship between bank competition, information asymmetry, risk, and loan pricing. Traditional economic theory too often regards increased competition as an unambiguous positive, but the corporate loan market demands a more nuanced understanding. The balance of power among banking institutions, borrower quality, and information flow combines to create market behaviors that defy the simplistic narrative of supply and demand.
Ultimately, the study “Adverse Selection in Corporate Loan Markets,” published in the Journal of Finance, constitutes a pivotal contribution to financial economics. It challenges stakeholders to rethink foundational assumptions and recalibrate regulatory frameworks with empirical rigor. As finance increasingly intertwines with technological innovation and data analytics, appreciating these dynamics will help safeguard both lenders and borrowers within the evolving corporate credit landscape.
This body of work shines a light on the hidden costs of competition, revealing that more banks do not necessarily mean cheaper or safer loans. It underscores the potent influence of asymmetric information and risk perception in shaping financial interactions. For markets, regulators, and businesses alike, it heralds a call for prudence, sophisticated analysis, and a willingness to embrace complexity rather than simplistic prescriptions.
Subject of Research: Bank competition, loan pricing, information asymmetry, risk assessment in corporate loan markets
Article Title: Adverse Selection in Corporate Loan Markets
News Publication Date: 9-Dec-2025
Web References: https://onlinelibrary.wiley.com/doi/10.1111/jofi.70011
References: Journal of Finance, DOI: 10.1111/jofi.70011
Keywords: Finance, Financial services, Economics, Business, Commerce, Corporations, Entrepreneurship
