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On the profitability and cost of relationship lending

Author

Listed:
  • Mitchell Berlin
  • Loretta J. Mester
Abstract
The authors provide some preliminary evidence on the costs and profitability of relationship lending by commercial banks. Drawing on recent research that has identified loan rate smoothing as a significant element in lending relationships between banks and firms, the authors carry out a two-stage procedure. In the first stage, the authors derive bank-specific measures of the extent to which the banks in their sample engage in loan rate smoothing for small business borrowers in response to exogenous shocks to their credit risk. In the second stage, the authors estimate cost and (alternative) profit functions to examine how loan rate smoothing affects a banks' costs and profits. On the whole, the authors' evidence says that loan rate smoothing is associated with lower costs and lower profits. These results do not support the hypothesis that loan rate smoothing arises as part of an optimal long-term contract between a bank and its borrower. However, we do find so me limited support for smoothing as part of an optimal contract for small banks early in our sample period.

Suggested Citation

  • Mitchell Berlin & Loretta J. Mester, 1997. "On the profitability and cost of relationship lending," Working Papers 97-3, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:97-3
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    References listed on IDEAS

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    1. Fried, Joel & Howitt, Peter, 1980. "Credit Rationing and Implicit Contract Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 12(3), pages 471-487, August.
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    More about this item

    Keywords

    Bank loans;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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