Currently, there is a revived interest in the impact of imperfect credit markets on business cycles and monetary policy analysis. There are three main approaches in the existing literature. The first approach focuses on the inclusion of a banking sector that produces loans and deposits, following Goodfriend and McCallum (2007). The second approach focuses on the costly state verification of Bernanke, Gertler, and Gilchrist (1999) and Carlstrom and Fuerst (1997). The third approach, the closest to ours, looks at introducing imperfect competition in the banking sector, either building on the Salop circular model (Andres and Arce 2009; Andres, Arce, and Thomas 2010) or exploring entry and exit into niche markets (Mandelman 2010). To the best of our knowledge, monetary policy implications of the market power in financial intermediation that takes the form of relationship lending has received only limited attention.
Lending relationships are directly aimed at resolving problems of asymmetric information as identified by Diamond (1984). In order to obtain better borrowing terms a firm might find optimal to reveal to its bank proprietary information that is not available to the financial market at large. Banks will have the incentive to invest in acquiring information about a borrower in order to build a lasting and profitable association. That way, the information flow between banks and firms improves, increasing the added value of a lending relationship (see amongst others, Boot 2000 and Petersen and Rajah 1994). On the other hand, as pointed by Rajah (1992), such relationships also have a (hold-up) cost. After a relationship is formed banks gain an information monopoly that increases their bargaining power over firms. Santos and Winton (2008), using data from the U.S. credit market, show that banking spreads can increase up to 95 basis points in a recession due to the fact that banks exploit this informational advantage after relationships are formed. Hence, banking spread movements driven by the existence of these relationships are significant and add to the "bank channel" effect of business cycle transmission and monetary policy. Figure 1 shows the loan spread to federal fund rate in the United States. It is clear that spreads tend to increase sharply during recessions (1991, 2001, and 2007). Although the loan spreads in the survey include both banking and credit spreads, by using the same dataset, Aliaga-Diaz and Olivero (2011) show that the evidence of countercyclical banking spreads remains when credit spread changes are controlled for.
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The hold-up or locked-in problem is also emphasized by the European Commission report on the banking sector (European Commission 2007). They conclude that competition problems within the industry are exacerbated as a result of information asymmetries between banks and their customers, which contribute to increasing switching costs. Furthermore, studies based on micro data point to a strong presence of lending relationships. For instance, Kim, Kliger, and Vale (2003) report that the duration of a lending relationship in Norway is about 13.5 years; Angelini, Di Salvo, and Ferri (1998), focusing on Italy, find an average duration of 14 years; Petersen and Rajan (1994) estimate an average duration of 11 years for the United States, and Degryse and Van Cayseele (2000) obtain an average duration of 7.8 years for Belgium. See also Degryse and Ongena (2008) and references therein for a survey of further empirical evidence of the positive link between lending relationships and banking spreads and profits. (1)
The primary objective of this article is to understand the implications of lending relationships on credit market outcomes, economic activity, and particularly on monetary policymaking. We therefore develop a parsimonious model that captures this key credit market channel in an otherwise standard New Keynesian model (NKM) with investment. …