Endogenous Product Differentiation in Credit Markets: What do Borrowers Pay for?

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Abstract
This paper studies strategies pursued by banks in order to differentiate their services from those of their rivals. In that way competition among banks is softened. More specifically we analyze if the bank size, the bank's ability to avoid losses, and its capital ratio can be used as strategic variables to make banks different and increase the interest rates banks can charge their borrowers in equilibrium. Using a panel of data covering Norwegian banks between 1993 and 1998 we find empirical support that the ability to avoid losses, measured by the ratio of loss provisions, may act as such a strategic variable. Our main finding is that borrowers in the market for credit line loans may discipline banks to avoid losses. We also find evidence that banks pass on parts of increases in their operating costs to credit line borrowers. However, we do not find evidence for the use of high capital ratio as a strategic variable that borrowers are willing to pay for.