COMMERCIAL BANK PRICE DISCRIMINATION AGAINST SMALL LOANS: AN EMPIRICAL STUDY*

Abstract

THE BUSINESS LOAN SURVEYS made by the Federal Reserve Board' reveal consistently that commercial bank loans of smaller sizes carry higher interest rates than do larger loans. Since size of loans and size of firm are highly correlated, this inverse relationship between interest rates and size of loans apparently has led many observers to conclude that banks discriminate against small businesses.2 It is reasoned that small businesses have fewer sources of funds available to them and hence have more inelastic demand curves for loans from a particular bank lender than have large businesses. The banks are thought to take advantage of this situation by charging higher interest rates on small loans than on large loans. An alternative hypothesis is that the observed differential between interest rates charged on large and small loans is due to a differential in the marginal costs of lending and risk between large and small loans. The elasticity of demand for loans faced by a bank is believed to be the same whether it is derived from large or small loans.3 Then, as one can demonstrate with familiar price theory analysis, higher marginal costs of lending and risk on small loans (if they exist) should be reflected in higher rates charged on these loans if the bank does not price discriminate against large loans.4 To demonstrate this alternative hypothesis, it is necessary not only to show that the marginal cost of lending and risk is higher for small than for large loans, but also to show that the difference in marginal costs is sufficient to explain the difference in marginal earnings.5 Thus, estimates of marginal earnings, marginal lending costs, and the marginal cost of risk per $100 change in the size of loans, with the effect of other relevant factors taken into account, are presented in this study. Data for 1959 and 1960 and 1961 (three cross sections) were analyzed by means of multiple regression analysis. The coefficients estimated were consistent among the cross sections.