An Empirical Analysis of Insider Rates vs. Outsider Rates in Bank Lending

This paper analyzes empirically the expected interest rates for insider (informed) vs. outsider (uninformed) lending. The analysis is based on a cross-section of small businesses that either borrow from an existing lender or borrow from a new lender. Existing lender rates proxy for insider rates and new lender rates proxy for outsider rates. The empirical results indicate that new lender rates are generally higher than existing lender rates in the total sample, which implies that outside rates are higher than inside rates. This finding is consistent with a benchmark theory of inside and outside rates, conditional on the borrower pool being of relatively high credit quality. The summary statistics indicate that the prediction is consistent with the data, given that the average firm in the data has a relatively high imputed probability of repayment. To further analyze the consistency of the theory and the data, the existing lender and new lender rates are compared across subsamples. According to the benchmark theory, the magnitude of the difference between the outside and inside rate is greatest for borrower pools in which the probability of success for a good firm is significantly higher than the probability of success for the average firm. The empirical results are consistent with this prediction. Lastly, two robustness checks are explored: the role of relationships and lending technologies. For the full sample, the results indicate that firms with an existing relationship at a new lender still pay a higher rate at the new lender relative to the existing lender rate. The new lender rate is also higher when controlling for similar lending technologies at the existing lender and most recent lender. However, the mitigating effect of an existing relationship does appear to be significant when controlling for lending technologies. * Ph.D. Candidate, Finance Department, Kelley School of Business, Indiana University, 1309 East Tenth Street, Bloomington, IN 47405. Tel: (812) 320-4714, fax: (812) 855-5875, email: [email protected]. The opinions expressed do not necessarily reflect those of the Federal Reserve Board or its staff. I would like to thank Greg Udell, Eric Leeper, Rich Rosen, Kim Huynh, Allen Berger, and Robert Marquez for helpful comments and discussions. I am also indebted to John Wolken for guidance with the data. All remaining errors are my own.