Bank Capital, Borrower Power, and Loan Rates

We test the predictions of several recent theories of how bank capital affects the rates that banks charge their borrowers. Key to all these theories is the notion that the relative bargaining power of a bank and its borrower are critical. We find that banks with low capital are more sensitive to borrower cash flow than are banks with high capital: lowcapital banks charge relatively more for borrowers with low cash flow, but offer relatively steeper discounts for borrowers with high cash flow. These effects are robust to controls for business conditions and bank fixed effects. Our results suggest that low bank capital generally toughens bank bargaining power, especially vis-a-vis low-cash-flow borrowers, but weakens bank bargaining power vis-a-vis high-cash-flow borrowers. This is consistent with Diamond and Rajan’s (2000) theory of bank capital. Also, consistent with earlier work, we find that rates for borrowers with access to public debt markets are relatively unaffected by their bank’s capital level, but in some specifications even these borrowers face some rate impact if their bank has low capital.