Monitoring and Market Power in Credit Markets

We study an oligopoly model of banking that allows us to evaluate the two leading explanations for banks’ ability to earn rents. In the model, banks can either invest in information acquisition, or in market power (through product differentiation). The two versions generate different predictions that are tested using panel data on Finnish local banks. We find that banks’ investments in branch network density and human capital (personnel) contribute to the information acquisition ability of banks as both loan interest rates and default costs are decreasing in these variables. We also find that managing customers’ money transactions enables banks to better control risks in their lending. JEL: D21, G21, L15