Competition, Financial Innovation and Specialization in Credit Markets

Abstract

I examine how commercial banks’ lending strategies respond to deregulation-driven credit market competition and the concurrent rise in securitization in the U.S. over the period 1976 to 2003. Banks display greater specialization in their loan portfolios after deregulation, with larger and younger banks making more loans backed by real estate, and smaller and older banks making more non-real-estate-backed commercial and personal loans. A large part of the shift in lending between these groups of banks appears to be driven by larger and younger banks making greater use of innovations in securitization markets. When larger and younger banks make more real-estate-backed loans, they exhibit larger fractions of defaults yet charge lower interest rates on these loans, consistent with these banks lowering the costs of lending and expanding credit for borrowers. In contrast, when smaller and older banks make more commercial and personal loans, they exhibit lower default rates and charge higher interest rates, consistent with these banks restricting lending to higher quality loans. The analysis presents new evidence on the role that competition and innovation in financial markets play in the equilibrium supply of credit.