MICROECONOMIC DETERMINANTS OF BANK LENDING: AN APPLICATION TO THE SPANISH CASE

Francisco Rodrguez and Santiago Carb

Universidad de Granada and FUNCAS (Fundacin de las Cajas de Ahorros Confederadas para la Investigacin Econmica y Social)

ABSTRACT
Recent changes in banking markets have generated a debate about the role of banks as lenders. Liberalisation and bank consolidation have been intensified while competitive pressures increase as nonbank competitors and mutual and pension funds expand. Many banks are reducing their share of loans in the balance-sheet and increasing the weight of securities. At the same time, banks are increasingly involved in off-balance sheet business such as derivatives and mutual funds. Deregulation, consolidation and the explosive growth of mutual fund business within depository institutions make the Spanish banking industry a particularly interesting case of study. What drives bank willingness to concentrate on banking activities? Which variables explain bank credit market competition? Using longitudinal data analysis we find that some factors such as bank size, relationship lending, the weight of mutual funds, different measures of bank concentration and efficiency have been specially significant for both bank specialisation in lending activities and the loan to deposit rate spread.

1. Introduction

Banks represent a crucial source of credit for many families and firms. In recent years, several changes have altered the structure of banking activities and the role of banks as lenders. Liberalisation has brought a decline in net-interest margins and the increasing competitive pressures led banks to invest a growing share of their assets portfolio in industrial participations and securities and to intensify their off-balance sheet business such as mutual and pension funds. However, bank loans' demand has increased during the last decade in many countries. Some institutional factors such as bank size, level of service, specialisation or relationship-lending have to be considered to explain how banks face this demand and the changes in the relative importance of loans on balance-sheet.

Microeconomic determinants of bank lending

Bank institutions have also faced increasing funding and regulatory pressures. Capital regulatory constraints have triggered a trend towards capitalisation as a response to minimum-reserves requirements and to reinforce the market-value of the bank institution itself. At the same time, changes in saving preferences have substantially affected bank liabilities. Households have shifted out from checking accounts and saving and time deposits to mutual funds. Even if banks may increase their non-interest income by selling mutual funds, the faster growth of these assets comparing with short-term bank creditors might become a substantial liquidity constraint for banks to create new loans.

The fast growth of off-balance sheet activities together with the processes of innovation, liberalisation and internationalisation, have contributed substantially to changes in the traditional view of banks as assets transformers -taking short-term liabilities and making long-standing loans. Although banks' traditional assets share is declining comparing to those of mutual or pension funds, the role of intermediaries in the financial system is still important. The way intermediaries are gathering a growing share of financial assets can be explained by two main reasons. In one hand, in those financial systems where bank institutions have been traditionally allowed to participate in activities such as mutual funds, they have rapidly controlled almost entirely that business. On the other hand, in some other countries -specially those with a marketbased financial system- banks have not been allowed until recent years to be involved in these activities and other types of intermediaries -as non-bank financial institutionshave boosted the relative importance of intermediation even while bank institutions share declined (Allen and Santomero, 1998).

Together with competitive pressures, advances in information technology, service improvements and capital regulation, banks have also experienced substantial transformations in their market structure in recent years. The removal of geographical branch restrictions in many countries and the global trend towards consolidation have changed the distribution of bank business at local, regional, nationwide and international levels. Market concentration together with factors such as size, efficiency and specialisation may then also affect bank loan supply in a particular territory.

Microeconomic determinants of bank lending

This paper aims to analyse the impact of mutual fund activities, regulation, market structure and size on bank lending using cross-section time-series analysis for a representative sample of Spanish commercial and saving banks from 1993 to 1998. Section 2 is a brief background of previous literature explaining the current role of banks as intermediaries and the future of bank traditional activities. Relationships between regulation, size and bank lending are explored in section 3. Section 4 reports on the main theories explaining the effects of changes in market structure and efficiency on bank prices and profits. The methodology and the definition of variables used in the empirical analysis are described in section 5. Section 6 carried out a panel data analysis for lending by banks in Spain regarding on changes in the ratio of loans on total assets and the loan to deposits rate spread from 1993-1998. The paper ends with some concluding remarks.

2. The changing structure of banking activities: Do mutual funds represent a trend towards disintermediation?

In a traditional model of bank behaviour in a competitive banking sector (see, for example, Freixas and Rochet, 1997, p.67), individual banks are seen as price takers and they will adjust their volume of loans (L) and deposits (D) in such a way that their marginal cost equal their intermediation margins (rL r and r (1-) rD) and bank profits are the sum of their loan and deposits margin minus their management costs (C(D, L)): (D,L) = (rL - r) L + (r (1- ) rD) D - C(D,L),

(1)

where M = (1- )D L expresses the net position of the institution in the interbank market.

Equation (1) represents the traditional role of bank as asset transformers. Even if bank funding and investment channels are not that simple, this equation illustrate the traditional functions carried out by financial institutions: their demand for liquidity (deposits plus interbank markets) and their supply of loans for a given set of prices. Bhattacharya and Thakor (1993) survey some of the main contributions in the banking literature to justify the special role of banks as financial intermediaries. Not only brokerage but also quality transformation -dealing with informational asymmetries and

Microeconomic determinants of bank lending

transaction costs- have been the main reasons reported on banking literature to shed light to the question of why banks are special.

As reported by Allen and Santomero (1998), transaction costs and information asymmetries can be -indeed- argued to explain the role of banks in traditional activities (basically taking deposits and making loans). However, in recent years with the substantial reduction in transaction costs and information asymmetries- some other factors as risk management and participation costs- have to be taken into account to explain properly the current and wider role of bank intermediaries in the global financial assets industry. 1 These factors can help to explain why banks are increasingly involved in off-balance sheet and fee-earning business (as mutual and pension funds)

Disintermediation can be seen as a transformation from institution-based to market-based financial systems. The increasing growth of mutual funds and non-bank financial institutions does not necessary mean a trend towards disintermediation. The question behind this discussion is actually if banks are losing a part of their importance as intermediaries. Allen and Santomero (1998) find that the share of assets held by banks (and insurance) firms is decreasing while non-bank financial institutions and mutual and pension funds have raised their importance as intermediaries in the United States.

As explained by Golter (1996), the large expansion experienced by mutual funds in the United States -when banks were not permitted until recent to deal with mutual funds- was first termed as disintermediation when actually depositors were using an intermediate channel to finance firms. A more appropriate term to describe this competition could be 'redesigned-intermediation'. When banks were eventually allowed to be involved in the mutual fund industry, a new set of possibilities was opened and they could actually increase their intermediation activities. The term disintermediation, however, has been used several times to describe the declining share of assets held by banks in the intermediation business.2
1

Participation costs are defined as those coming from the day-to-day learning of (and participation in) the markets while risk management is included because of the increasing complexity and number of market instruments and the transfer of the inherent risk of operating in those markets to the financial intermediaries. 2 Gallo, Apilado and Kolari (1996, p.176), for instance illustrate how the dramatic decline in short-term

Microeconomic determinants of bank lending

Schmidt, Hackethal and Tyrell (1999) report on the state of bank business in France, United Kingdom and Germany finding that there is neither a trend towards disintermediation nor towards a significant declining of banking activities. However, they observed how non-bank financial institutions are increasing their role as financial intermediaries putting banks under pressure (specially in the case of France).

The effects of mutual funds growth on banking activities are mixed. The pace of development and the channels of distribution for mutual funds vary significantly across countries. 3 In the United States -where these assets are mainly managed by nonbank financial institutions- mutual funds represent a direct competition for banks, as they provide liquidity and check-writing facilities -specially the money-market- similar to those services offered by bank deposits. In this sense, Scott (1995) argue that mutual funds might represent a threat for the savings and time deposits of commercial banks, becoming an alternative for the current payment system. Gorton and Penacchi (1993) show how a potential and substantial share of lending can move away from depository to non-bank financial institutions.

In some other countries, as in Spain, Germany or France, mutual fund assets are largely controlled by banks and distributed via their branch network. Even if banks may rise their gross income by selling mutual funds, they have to face the funding pressures coming from a decline in deposits growth rates comparing to those of mutual funds. Kaufman and Moat (1994) describe how banks have reduced their share in shortterm business credit to a larger extent than their share of total assets as a result of the expansion of new types of financial institutions. Nevertheless, as Schmidt, Hackethal and Tyrell (1999) have pointed out, the decreasing role of bank institutions in the United States should not be extrapolated to the European countries assuming a general decline of banks in all the industrial countries.

Even if there is not a common trend towards disintermediation -and if this is sometimes understood as a lost of importance of commercial banks- mutual funds has to

interest rates during the 1990s encouraged depositors to shift to mutual funds and banks reacted focusing heavily on the mutual fund business to avoid 'disintermediation'. 3 See Walter (1999) for a comprehensive view of the differences of mutual fund growth internationally.

Microeconomic determinants of bank lending

be taken into account because of the many implications they have on banking activities, in particular in those countries, as in Spain, where mutual funds experienced an unprecedented growth during the nineties. Banks are specially well-positioned to offer these saving products because of their distribution channels, long-standing customer relationship and cross-selling opportunities. A new question arises: Do mutual funds activities carried out by banks contribute to a decrease in traditional -say lendingbanking activities?

Gallo, Apilado and Kolari (1996) analyse the impact of mutual funds activities on bank risk and profitability. Their results suggest that mutual funds reduce bank risk (but not unsystematic risk) and increase the return on assets (ROA) of banks.

Even if mutual funds may reduce the pressures of the dramatic drop in net interest margins they pose many other implications for banking activities as they are perceived by depositors as a substitute for deposit accounts. Mutual funds are a
70% 60% 50% 40% 30% 20% 10% 0%

FIGURE 1. MUTUAL FUNDS AND DEPOSITS GROWTH RATES IN SPAIN (1992-1998)

Mutual funds (left scale) Deposits (right scale)

12% 10% 8% 6% 4% 2% 0%
1993 1994 1995 1996 1997 1998

1992

profitable business but they do not provide banks with liquidity (as deposits do) to create new loans. This is likely the case of Spain where mutual funds growth rates have been considerably higher than those of deposits (figure 1).

As mutual funds grow rapidly and deposit accounts shrink sharply banks may
FIGURE 2. BANK LOANS GROWH AND MUTUAL FUNDS TO DEPOSITS RATIO (1991-1998)
Bank loans growth rate (left scale) Mutual funds/deposits (right scale)

face some liquidity shortages to create new loans, as it happened in Spain during the second half of the nineties (figure 2).
0,800 0,600 0,400 0,200

20% 15% 10% 5%

Some

other

alternatives relevant to

became generate

increasingly

liquidity, as the interbank market and securitisation. These alternatives,

0% 1991 1992 1993 1994 1995 1996 1997 1998

however, could be not enough by themselves to solve liquidity shortages and this type of funding is expensive compared to deposits. Berlin and Mester (1999) argue that one of the factors explaining the 6

Microeconomic determinants of bank lending

declining role of the banking sector in the credit markets has been the weak growth of core deposits.

Small and medium depository institutions (specially savings banks) are intensifying their participation in bank credit markets and becoming increasingly relevant in loan supply to households and firms at the local and regional levels. As large banks enrolled in the mutual fund and securities business strongly, they have decreased the relative weight of loan over total assets compared with small banks although diversification and changes in the banking industry are affecting all types of banking institutions.

3. Regulation, size and the role of bank as lenders

Capital requirement standards, competition, liberalisation and the relaxation of barriers to interstate mergers and interstate branching in many countries have represented a challenge for the banking industry. Widespread changes in regulation have largely contributed to a substantial transformation in bank strategies and activities. There is a concern in the banking literature about the future role of banks in lending activities, specially for those loan categories -as small business- that rely more on bank finance. Shrieves and Dahl (1995) attempt to identify the causes of the so-called 'credit crunch' at the beginning of the nineties in the United States concluding that not only credit market factors but also new capital regulations should be consider to clarify the contraction of bank lending.

Relationships between bank lending and capital have been extensively studied recently. Minimum reserves requirements and external market pressures have stimulated an increase in bank capital to asset ratios. Changes in bank capital requirements have affected bank asset and liability structure. These effects have been very different across countries depending on the level of the capital to assets ratio held by banks and the characteristics of the minimum reserves regulation prior to the adoption of the new "own funds" requirements standards.

Microeconomic determinants of bank lending

Peek and Rosengren (1995) explained how a reduction in capital -together with binding capital requirements- led banks to both reductions in lending (more than dollar per dollar) and deposits. When banks are not constrained by binding capital requirements, if there is any capital reduction, deposits increase and loans fall (but less than dollar per dollar).

Changes in bank capital might then affect bank loans and real economic activity. Some relevant factors have been observed in many studies related to changes in bank size. Hancock and Wilcox (1998) find that reductions in capital levels in the United States between 1989 and 1992 in both large and small banks tend to reduce bank lending and real economic activity. These negative effects were found to be higher for small banks as they are supposed to offer 'high powered' loans (that is, small firms and households are more dependent on the credit given by small banks).

There is a concern about the future of bank lending to certain borrowers assuming that small firm finance rely more on depository institutions and specially on those small-medium banks that operate at regional and local levels. Small banks possess better information about the local (regional) markets they are operating in (Samolyk, 1999). Strahan and Weston (1998) study the relationships between lending to small business, bank institution size and complexity and consolidation. Firstly, they find evidence of an increase in the importance of small business loans on small banks' portfolio while large banks expand their share of large firms loans (and decrease small business lending) rapidly with size. Secondly, mergers and acquisitions between small bank institutions increase bank lending while other types of merger does not present a significant change.

Hancock and Wilcox (1994) develop a model of bank loan supply and borrower demand for bank credit. Their empirical findings suggest that loan interest rate were positively related to bank supply of loans while loan delinquency rates affected negatively. Bank capital was found to have a positive effect on bank loan supply either to meet minimum reserves requirements or because a bank itself might be willing to increase its capital to asset ratio considering market-related pressures.

Microeconomic determinants of bank lending

Houston and James (1998) analysed the relationship between bank lending, organisation structure (affiliated and unaffiliated banks) and size. As Strahan and Weston (1998), they find evidence of size-related specialisation consisting in large bank offering different types of bank loans from those given by small banks. On one hand, large banks might benefit from internal capital markets through subsidiaries and allocate capital more efficiently than small banks. On the other hand, unaffiliated banks (mainly small and medium size banks) have a higher proportion of liquid assets and capital to assets ratios. Bank lending in large banks subsidiaries is less sensitive to cash flow evolution-as they can benefit from internal capital markets- and the correlation of affiliated loan growth with aggregate lending in the state they operate is higher than for unaffiliated banks. The study also suggests that lending in affiliated banks is more sensitive to changes in local market conditions -offering more money when the market follows an upward trend and reducing lending when conditions are not so favourable-. Local borrowers should prefer to establish a lending-relationship with unaffiliated banks -strongly linked with local conditions-.

Another relevant point to clarify the changing patterns in the role of banks as lenders is relationship lending. A relationship between depository institutions and bankdependent borrowers in a long-standing basis provide banks with precious information (Petersen and Rajan, 1994). Relationship lending may determine, to a certain extent, the special role of depository institutions as lenders. Bank lending to small firms and households rely specially in relationship lending advantages to solve the problem of information asymmetries.

Berger and Udell (1995) illustrate lending relationships using information on loan rates and collateral requirements of lines of credit. As Petersen and Rajan (1994), they show how banks obtain information during the course of their relationship with borrowers to adjust loan contract terms. Relationship lending is, then, found to be very useful in describing the current role of banks in finance.

These relations have been also pointed out by Samolyk (1999), showing that small-medium banks focus more on relationship lending and standardised lending products such as credit-card than large-complex bank holding companies. Petersen and Rajan (1995) illustrate how competition in credit markets may determine bank lending 9

Microeconomic determinants of bank lending

to credit-market constrained (bank-dependent) borrowers as concentration in a given credit market may benefit from lending-relationships.

Berlin and Mester (1999) study the influence of deposits in relationship lending. A risk-sharing agreement is implicit. Deposits are shown as inter-temporal contracts that smooth banks' cost of funds. Borrowers' cost of funds is protected from exogenous shocks -and lending shortages- in a downturn. Borrowers establish durable contract relationships with bank lenders and this contract reduce the likelihood of a credit crunch and contribute to loan rates smoothing.

4. Market structure and bank lending

Market competition and efficiency in credit and deposit markets may alter bank prices and profits intensely. Relationships between performance and profits and market structure have relied upon two major hypotheses: market concentration -which assert that market imperfections result in higher prices and profits- and efficiency structure hypothesis -more efficient institutions might have lower costs and higher profits.4

Performance, prices, concentration and efficiency measures used to determine crucially the empirical findings. Berger (1995) has criticised the use of market concentration measures as a proxy for bank efficiency They argue that market share may account for many different factors related to market power -as product differentiation- and not only efficiency (see also Maudos, 1998).

Molyneux, Lloyd-Williams and Thornton (1994) attempted to identify the features of the Spanish banking industry market structure during the period 1986-1988.

These hypotheses are well developed by Berger (1995) showing two possible related theories for each of both concentration and efficiency hypotheses. The exercise of concentration market-power may consist, first, in either higher loan to deposits rate spread as a consequence of competitive imperfections in the market (structure-conduct-performance hypothesis) or, alternatively, because firms with large market shares and differentiated products may increase their profits and rise there prices deliberately (relative-market power hypothesis). Two different theories are held also to explain efficient-structure hypothesis. The first one of them asserts that a reduction in costs -as a result of better managerial abilities and/or production technologies than competitors- can lead a bank to higher profits and market shares (Xinefficiency hypothesis). The second theory rely on significant differences in economies of scale across depository institutions (scale-efficiency hypothesis)

10

Microeconomic determinants of bank lending

They found support for traditional structure-conduct-performance hypothesis. However, they use a market share variable to test for efficiency-structure hypothesis.

Maudos (1998) study the relationship between market structure and bank performance (ROA and ROE) in Spanish banking from 1990 to 1993 employing a direct measure of efficiency using translog functional forms. Two hybrid hypotheses are tested together with the usual efficiency-structure and market concentration hypotheses: the modified efficient-structure hypothesis -which postulates that changes in bank performance are motivated by efficiency plus a residual effect of market share-, and the collusion/efficiency hypothesis which states that performance is related to both bank efficiency and concentration. The evidence in this study support the modified efficient structure hypothesis as efficiency and market share affect bank performance significantly5 while concentration -as a proxy for market power- was found to be irrelevant.

The level of competition in the relevant market has to be inferred appropriately to describe market structure. A common measure to establish a relation between market power and market concentration is the Herfindahl-Hirschman Index (HHI).6 As there is not information available for the distribution of deposits (or loans) across regions (or provinces) in Spain, previous studies of the banking industry have used branch information as a proxy for deposit concentration. We consider provincial HHI computations as many Spanish depository institutions operate in a few provinces and provincial HHI should be, then, far more relevant than regions. The relevant market for local depositors and borrowers is the province level since they rarely have access to markets outside their own province.

Figure 3 shows the average branch concentration for both local (provincial) and regional markets in Spain from 1986 to 1998. Although both measures of market concentration exhibit a similar trend, HHI computations for provinces were found higher in average and more sensitive to changes in market conditions. In 1989,
5

The introduction of efficiency in regressions where the market share variable is statistically significant does not affect the value of the parameter estimate of market share prior to the introduction of efficiency in regressions which indicates that market share is effectively a proxy of market power in these equations. 6 This index can be defined as the sum of the squared market shares of bank institutions in their relevant market. The HHI has been extensively used as it considers both the distribution of the market share and

11

Microeconomic determinants of bank lending

geographical branch restrictions were eliminated in Spain. At the beginning of the 1990s, many institutions (basically, saving banks) merged as competition intensified and concentration grew. However, the effects of liberalisation have progressively reduced concentration in regional and local markets to levels similar to those of the beginning of the period.

Even if there is no information available of bank loans and deposits at local and regional levels and previous studies of Spanish banking
0,250 0,200 0,150 0,100 0,050 0,000

FIGURE 3. AVERAGE BRANCH CONCENTRATIO (HHI) IN SPANISH LOCAL AND REGIONAL MARKETS (1986-1998)

PROVINCIAL REGIONAL

industry have only used branch

1986

1988

1990

1992

1994

1996

1998

distribution data as a proxy for deposit and loan market concentration, the analysis could be improved using the average loan (deposit) branch values to compute the HHI for loan and deposit markets at both regional and local levels and compare them.

Finally, some caveats must be taken into account when using concentration measures as an indicator of market power. Relying on theoretical models of conduct, Cetorelli (1999) illustrate how market power and market concentration measures (such as HHI) are not always justified. Theories which regard a monotonic relationship between market power and concentration measures will be correctly identified under some restrictive assumptions about depository institutions and borrowers behaviour7. This study shows how different tests of the structure-conduct-performance (SCP) hypothesis for the Italian banking industry -using indirect concentration measures of market power (HHI) and direct econometric analysis of banks competitive behaviourlead to different results. While the concentration measures provided with evidence that support a progressive approximation from a high level of competition to a gradual increase of concentration and market power, econometric results contradicted these hypothesis suggesting a trend from less-competitive conditions to a substantial level of

the number of bank institutions in each market. 7 Cetorelli (1999) illustrate how alternative measures of market structure based on econometric modelling of market demand and supply conditions -conjectural analysis- may provide an accurate information about bank's competitive behaviour. HHI measures of market concentration will be measuring market power properly when banks competitive behaviour is similar to Cournot oligopoly, showing that an individual change in bank prices will not be followed by changes in prices by competitors.

12

Microeconomic determinants of bank lending

market competition at the end of the period considered. Therefore, econometric analysis suggest a rejection of SCP hypothesis while HHI data contradict these results.

5. Relevance of the Spanish case, methodology and data

This paper aims to test for the main determinants of bank lending. In particular, it studies the effects of a set of posited explanatory variables on bank lending likelihood -measured as the importance of loans on bank portfolio- and on the loan to deposit rate spread in Spain from 1993 to 1998. The Spanish banking industry is a particularly relevant archetype for our empirical purposes as many of the processes identified in sections 2-4 have been specially significant in Spain during this period. A high degree of liberalisation -with a substantial decrease in short-term interest rates- together with a trend towards consolidation -with differential strategies for small and large depository institutions- and a massive growth of bank mutual fund off-balance-sheet business, have been some of the main transformations in the Spanish banking industry of the last decade.

As we consider Spanish banks involvement in the mutual fund business as a meaningful variable to illustrate some of the structural changes occurred in banking activities, the analysis has to be limited to those institutions for whom mutual fund portfolio information is available and can be individually identified.8 Nevertheless, this restriction does not affect significantly the conclusions derived from our empirical analyses since the 38 institutions included in the sample concentrate more than the 70 per cent of the total banking industry assets.

We use longitudinal (panel) data techniques to analyse both cross-section and time series observations. One of the main contributions of longitudinal data analysis is that unobservable differences -persistent heterogeneity- across individuals (banks in our case) can be modelled under certain assumptions. If this individual-specific effect is supposed to be a random variable that is uncorrelated with the explanatory ones -and then, a part of the error term- then, a 'random effects' estimation should be applied9. If
8

Some small banks that sells mutual funds delegate the fund portfolio management to a company that serves a few banks and keep selling and distribution to customers in branches. 9 Applying random effects, OLS estimators will be not efficient and the appropriate method of estimation will be Generalised Least Squares (GLS).

13

Microeconomic determinants of bank lending

we instead suppose that individual effects may vary across time but be constant across individuals, then the 'fixed effects' estimation would be more appropriate and Ordinary Least Squares (OLS) regression will yield unbiased estimators of the coefficients of the parameters of interest10.

Two equations are tested using fixed and random effects estimators. The dependent variable in the first equation will be the relative weight of bank loans on bank assets portfolio -regarding the effect of structural changes in the relative importance of lending activities- while the second one regress a group of explanatory variables on the loan to deposits rate spread -analysing changes in loans and deposits prices. The first equation is defined as follows:

LNTA = f (NB, LLSS, GDP, SPR, LCMS, MFST, DUMM96, TA)

(2a)

We will also consider the capital11 to assets ratio (CATR) to test for relationships between bank capital and lending likelihood and exclude total assets (TA) because correlation between both variables alter estimations significantly introducing bias12. When including CATR we will refer to this equation as equation (2b).

The dependent variable (LNTA) is loans over total assets, measuring the evolution of the importance of bank loans on total assets. NB is the logarithm of bank branches providing with a measure of the distribution network (service). Those banks with a large number of branches or increasing their physical distribution channels to customers over time are expected to have a higher proportion of their assets invested in lending. Loans are mainly commercialised in bank offices and borrowers -specially local ones- value bank branching facilities.

TA refers to the log of total assets. Small depository institutions in Spain -and specially savings banks- are specialised in lending activities and operate in specific local
10

Another advantage of using panel data improves estimations even with an incomplete list of explanatory variables. It should be noted, however, that when random effects estimations are valid, fixed effects still produce consistent estimates of the variables of interest. 11 Tier 1 and Tier 2 capital definitions. 12 While introducing 'capital to assets ratio' and 'total assets' together in the same equation was found to introduce a serious problem of multicollinearity between both variables, the introduction of the number of branches together with the capital to assets ratio did not alter significantly the coefficients of the

14

Microeconomic determinants of bank lending

or regional areas while large institutions -in particular, large commercial banks- have diversified their investment portfolios -maybe reducing the relative importance of loans on balance-sheet- and working nationwide. Then, a priori, a negative relationship between size and loans over total asses is expected.

We also include LCMS and LLSS as variables related to bank credit management. LCMS stands for loan commitments and it includes lines of credit. As these relationships grow, the share of loans maintained by a bank might rise because of a better information about borrowers and long-standing relationships. Unfortunately there is no data available of contract variables (such as duration of loans or collateral) for Spanish banks to test more appropriately the value of relationship lending over time. LLSS refers to loan losses -as a ratio of non-performing loans on net-interest margins. As LLSS grow, bank credit risk increases and lending over total assets might decrease as a result of a higher credit risk.

The loan to deposits rate spread (SPR) accounts for the influence of deposits and loan prices on bank lending. Higher differences in loan and deposit prices may encourage banks to concentrate more on bank lending as a higher spread could be the result of a lower level of competition in their relevant credit market.

MFST is the ratio of mutual funds bank investment on short-term creditors (deposits, interbank market liquidity and short-term securities issued). As this ratio increases, bank liquidity constraints may rise with lending if depositors shift out from deposits to mutual funds and bank willingness to lend could decline.

The GDP growth rate has been included as a proxy for macroeconomic conditions and computed as a branch-weighted average of the regional GDP for those regions where the bank operates. Since interest rates drop sharply after 1996 and loans demand rises substantially after this year, a dummy variable (DUMM96) has been introduced to control for changes in lending demand prior and after 1996. The variable takes the value 0 prior to 1996 and 1 otherwise.

parameters comparing to those obtained before including the capital to assets ratio.

15

Microeconomic determinants of bank lending

Equation 3 -where the dependent variable will be the loan to deposit rate spread- is specified as follows:

SPR = f (NB, HHID, MSD, CINFF, MFST, LCMS, TA) (3a)

where HHID and MSD are the Herfindahl-Hirschman Index and market share computed for deposits as a branch-weighted average of provincial HHI and MS for deposits13. HHIL and MSL -HHI and MS for loans- will be alternatively included in equation (3b) -and computed following the same methodology- to contrast if deposit and loan market concentration bring us to the same conclusions about the loan to deposit rate spread (SPR). We expect HHID (L) and MSD (L) will be positively related to the SPR as loan (deposits) prices will be higher (lower) in less-competitive markets. CINNF stands for cost inefficiencies and is defined as the ratio of operating costs over gross income. Most efficient banks are expected to operate in most competitive markets and prices (not necessarily profits) should be lower. MFST is also included in equation 3 since those banks investing in mutual funds business usually operate in more competitive and larger markets and their loan to deposits spread might be lower.

TABLE 1. VARIABLES DEFINITION AND SUMMARY STATISTICS (1993-1998) VARIABLE DEFINITION MEAN STD. DEVIATION LNTA LOANS OVER TOTAL ASSETS 0.456540 0.327386 NB NUMBER OF BRANCHES (log) 5.36790 1.800301 LLSS LOAN LOSSES 0.099731 0.266741 GDP GDP GROWTH RATE 0.059123 0.014887 SPR LOAN TO DEPOSITS RATE SPREAD 0.014798 0.014080 CAGR LOAN COMMITMENTS (log) 11.38944 2.051159 MUTUAL FUNDS OVER SHORT-TERM MFST 0.256327 0.345916 CREDITORS TA TOTAL ASSETS (log) 13.69263 4.111287 CATR CAPITAL TO ASSETS RATIO 0.061920 0.041806 CINFF COST INEFFICIENCIES 0.638429 0.186098 HHIL HHI (LOANS) 0.142159 0.050624 MSL MARKET SHARE (LOANS) 0.105091 0.099999 HHID HHI (DEPOSITS) 0.155488 0.057145 MSD MARKET SHARE (DEPOSITS) 0.089777 0.152411

Variable means and standard errors are shown in table 1. Data frequency is semi-annual. The number of total panel observations vary from 411 (equations 2) to 383

13

Deposit distribution has been computed using provincial branch distribution.

16

Microeconomic determinants of bank lending

(equations 3) depending on data availability. Pearson correlation coefficients are shown in the Appendix.

6. Panel Data Results

Regression results for the equation (2a) where the dependent variable is the ratio of loans over total assets (LNTA)- are shown in Table 2. Fixed (FE) and random effects (RE) estimations are, in general, very similar . In equation (2a), the NB is found to be significant and, as expected, positive when RE is applied, indicating that the weight of loans might increase as a result of a larger physical network. LLSS is also significant for RE and achieve the expected negative sign, reflecting the impact of a higher credit risk on bank lending. According to our hypotheses, LCMS and LNTA are positively and significantly related (both FE and RE) as effective lending, borrower monitoring and lending relationship will improve with loan commitments such as credit card agreements.

As expected, MFST is strongly and significantly related to LNTA. Deposit accounts can be found less attractive comparing to mutual funds, specially in Spain where mutual fund income-tax treatment has been significantly favourable. If banks focus on mutual funds and these assets grow faster than deposits and other short-term creditors, depository institutions may be raising their profits selling mutual funds and become less dependent on lending.

We find a positive effect of SPR (when applying RE) on LNTA, as banks are expected to specialise more in lending activities when they can benefit of a higher spread. Bank size (TA) coefficient is found to be negative and significant. Small banks (as many saving banks) are more specialised in lending while large banks diversify more their investment portfolios. The dummy variable controlling for changes in lending demand is only significant for RE estimations. GDP coefficients were not found significant.

17

Microeconomic determinants of bank lending

TABLE 2. PANEL REGRESSION RESULTS ON LENDING OVER TOTAL ASSETS OF POSITED EXPLANATORY VARIABLES (Equations 2a and 2b) Sample period: 1993(1)-1998(2) Values for t-statistics in parenthesis FIXED RANDOM EFFECTS EFFECTS (a)

Equation (2a)
CONSTANT NB LLSS GDP DUMM96 SPR LCMS MFST TA NUMBER OF BRANCHES (log) LOAN LOSSES GDP GROWTH RATE 1996 DUMMY LOAN TO DEPOSITS RATE SPREAD LOAN COMMITMENTS (log) MUTUAL FUNDS OVER SHORT-TERM CREDITORS TOTAL ASSETS (log) -------0.106266 (1.34) --0.076116 (-1.43) 1.313689 (1.43) 0.082119** (2.31) 0.750071 (0.82) 0.078147*** (2.66) -0.357993*** (-2.75) -0.614726*** (-7.09) 0.36 411 -------0.101923 (1.22) -0.07621 (1.22) 0.300085 (0.31) 0.030488 (0.84) 1.559564* (1.64) 0.079967*** (2.60) -0.247841** (-1.77) 2.139037*** (3.79) 0.31 411 1.507455*** (6.41) 0.063708*** (2.94) -0.096800* (-1.84) 0.765124 (0.86) 0.044024 (1.46) 1.532221* (1.68) 0.10412*** (4.83) -0.152533** (-2.50) -0.437991*** (-7.33) 0.39 411 -0.141046 (-0.87) 0.032287 (1.47) -0.095378** (-1.72) 0.696827 (0.74) 0.045366 (1.43) 2.262382** (2.37) 0.024387 (1.30) -0.107892** (-1.72) 1.480740*** (3.30) 0.32 411

Adjusted R2 Number of observations CONSTANT NB LLSS GDP DUMM96 SPR LCMS MFST CATR NUMBER OF BRANCHES (log) LOAN LOSSES GDP GROWTH RATE 1996 DUMMY LOAN TO DEPOSITS RATE SPREAD LOAN COMMITMENTS (log) MUTUAL FUNDS OVER SHORT-TERM CREDITORS CAPITAL TO ASSETS RATIO

Equation (2b)

Adjusted R2 Number of observations

(a)

Random effects estimations have been estimated applying Generalised Least Squares Variance Components model * statistically significant at 10 per cent (two-sided) ** statistically significant at 5 per cent (two-sided) *** statistically significant at 1 per cent (two-sided)

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Microeconomic determinants of bank lending

In equation (2b) the capital to assets ratio has been included as explained in section 5. As expected, the CATR is strongly and positively related to LNTA. By increasing their capital to assets ratio, depository institutions meet their minimum reserves requirements and increase their lending activities14. Results for the rest of the parameters are generally similar to those of equation (2a). SPR, however is more significant (for both RE and FE) in equation (2b) while NB is not significant in this equation (neither RE nor FE estimations).

Results for equations 3 where loan to deposits rate spread (SPR) is the dependent variable- are shown in Table 3. Results are again very similar in both fixed and random effects. In equation (3a) where deposit concentration measures were usedthe number of branches (NB) is found to be significantly related to SPR as growing physical distribution network could increase traditional activities such as lending. HHID is found to be significantly and positively related to SPR as a higher concentration in local (provincial) markets may result in a higher (less competitive) loan to deposits spread while MSD was not found significant in any case. It should be noted, however, that when introducing regional computations of HHID, the coefficients (not shown) were not significant in any case since these wider, regional measures might be less representative of actual relevant market concentration. Using branch-weighted average of local HHIL we obtain a more meaningful variable for bank market concentration even for those banks that operates in different local (regional) markets. CINNF ratio is also positively and negatively related to SPR suggesting that more cost-efficient banks operate in more competitive markets. Bank size (TA) coefficient shows a negative sign suggesting that smaller banks exhibit higher spreads between loan and deposit rates than their larger competitors.

The same comments apply to results obtained in equation (3b) when HHIL and MSL are tested instead of deposit measures. However, the results obtained introducing loan measures are less statistically significant than those of deposits.

14

A recent study carried out by Altunbas, Carb and Gardener (forthcoming) suggest that CAR (capital adequacy ratios) have successfully contributed to bank capital augmentation in Spain.

19

Microeconomic determinants of bank lending

TABLE 3. PANEL REGRESSION RESULTS ON LOAN TO DEPOSITS RATE SPREAD OF POSITED EXPLANATORY VARIABLES (Equation 3) Sample period: 1993(1)-1998(2) Values for t-statistics in parenthesis FIXED RANDOM EFFECTS EFFECTS (a)

Equation (3a) (deposit market concentration measures)

CONSTANT NUMBER OF BRANCHES (log) COST INEFFICIENCIES HHI (DEPOSITS) MARKET SHARE (DEPOSITS) LOAN COMMITMENTS (log) MUTUAL FUNDS OVER SHORT-TERM CREDITORS TOTAL ASSETS (log) R2 Adjusted R2 Number of observations CONSTANT NUMBER OF BRANCHES (log) COST INEFFICIENCIES HHI (LOANS) MARKET SHARE (LOANS) LOAN COMMITMENTS (log) MUTUAL FUNDS OVER SHORT-TERM CREDITORS TOTAL ASSETS (log) R2 Adjusted R2 Number of observations
(a)

-------0.001709 (0,45) 0.013072*** (3.59) 0.213067*** (3.45) 0.041181 (0,92) -0.003228** (-2.17) -0.021482*** (-3.75) -0.016346*** (-2.85) 0.37 0.29 383 -------0.000250 (0.065) 0.013892*** (3.73) 0.030133 (1.42) -0.020252 (-0.85) -0.003657** (-2.42) -0.22292*** (-3.83) -0.018352*** (-3.14) 0.34 0.26 383

0.036686*** (2.64) 0.006011*** (4.74) 0.016612*** (3.42) 0.096379*** (3.09) -0.010239 (-0.90) -0.002739** (-2.14) -0.009461*** (-3.07) -0.007066* (-1.81) 0.30 0.29 383 0.038627*** (2.80) 0.004338*** (3.79) 0.010940*** (3.20) 0.039426** (2.31) 0.003709 (0.33) -0.001869 (-1.48) -0.008972*** (-2.98) -0.006214 (-1.59) 0.28 0.27 383

Equation (3b) (credit market concentration measures)

Random effects estimations have been estimated applying Generalised Least Squares Variance Components model * statistically significant at 10 per cent (two sided) ** statistically significant at 5 per cent (two sided) *** statistically significant at 1 per cent (two sided)

20

Microeconomic determinants of bank lending

7. Concluding remarks

The banking industry has undergone substantial transformations in recent years. Liberalisation has resulted in higher competition and consolidation. At the same time, non-bank competitors are offering services similar to those of depository institutions and mutual and pension funds together with derivatives and securities-, competing with bank traditional activities. Using panel data techniques, this paper has studied the main determinants of bank lending in Spain form 1993 to 1998. A set of posited variables is regressed on the ratio of bank loan to total assets and on the loan to deposits rate spread. Spanish banks have been specially affected by events such as an explosive mutual funds growth, a recent process of bank liberalisation and a trend towards consolidation that make the Spanish banking industry an specially interesting study case.

Our main results suggest that smaller banks specialise more in lending and work with higher loan to deposits rate spreads. Loan commitments such as credit cards agreements may also improve bank borrower information and lending relationships resulting in a higher proportion of bank loans on balance sheet and lower (higher) loan (deposits) rates. Some interesting conclusions are derived also from bank mutual fund investment. In the last decade Spanish households have been shifting out from deposits to mutual funds and banks have found problems to obtain liquidity. Many banks (specially large commercial banks) have focused intensely in mutual funds business. Our results indicate that this process has reduced the relative weight of loans on total assets when banks mutual fund business has grown considerably faster than short-term creditors. Finally, measures of concentration for both loan and deposits local markets and cost-inefficiencies are found to be positively related with higher loan to deposit spread and less competitive markets.

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Microeconomic determinants of bank lending

REFERENCES
ALLEN, F. and SANTOMERO, A.M. (1998): "The theory of financial intermediation". Journal of Banking and Finance 21, pp. 1461-1485. ALTUNBAS, Y., CARB, S. and GARDENER, E.: "The impact of CAR on bank capital augmentation in Spain". forthcoming in Applied Financial Economics. BERGER, A. (1995): "The profit structure relationship in banking-Test of marketpower and efficient-structure hypotheses". Journal of Money, Credit and Banking, vol.27, n2 pp.404-431. BERGER, A. and G. UDELL (1995): "Relationship Lending and Lines of Credit in Small Firm Finance". Journal of Business, 68, n3. BERLIN, M and MESTER, L.J. (1999): Deposit and Relationship Lending. The Wharton School Institutional Center. WP. 99-03 BHATTACHARYA, S. and THAKOR, A.V. (1993): "Contemporary Banking Theory". Journal of Financial Intermediation 3, pp. 2-50. CETORELLI, N. (1999): "Competitive analysis in banking: Appraisal of methodologies". Economic Perspeectives, n1, vol.2. Federal Reserve Bank of Chicago. First Quarter. 2-15. FREIXAS, X. and ROCHET, J.C. (1997): Microeconomics of Banking. The MIT Press. London. England. GALLO, J.G., APILADO, V.P. and KOLARI, J.W. (1996): "Commercial bank mutual fund activities: Implications for bank risks and profitability". Journal of Banking and Finance,20 pp. 1775-1791 GOLTER, J, W. (1996): "Banks and Mutual Funds". Federal Deposit Insurance Company Banking Review. Article II. Vol 8, n3. pp. 10-20. GORTON, G. and PENNACCHI, G. (1993): "Money market funds and finance companies: Are they the banks of the future?" In Structural Change in Banking. M. Klausuner and L. White. New York: Irwin. HANCOCK, D. and WILCOX, J.A. (1998): "The credit crunch and the availability of credit to small business". Journal of Banking and Finance, 22. pp. 983-1014. HANCOCK, D. and WILCOX, J.A (1994): "Bank capital, loan delinquencies and real state lending". Journal of Housing Economics, 3 (2), pp.121-146.

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Microeconomic determinants of bank lending

HOUSTON, J.F. and JAMES, C. (1998): Do bank internal capital markets promote lending?. Journal of Banking and Finance, 22, pp. 899- 918. KAUFMAN, G.G. and MOTE, L.R. (1994): "Is banking a declining industry?". Economic Perspectives. Federal Reserve Bank of Chicago. May/June 1994. Vol. XVIII, Issue 3. pp. 2-21.

MAUDOS, J. (1998): "Market structure and performance in Spanish banking industry using a direct measure of efficiency. Applied Financial Economics.8, 191200.

MOLYNEUX P., LLOYD WILLIAMS, D.M. and THORNTON, J. (1994): "Market structure and performance in Spanish Banking". Journal of Banking and Finance, 18, pp.433-444.

PEEK, J. and ROSENGREN, E. (1995): "The Capital Crunch: Neither a Borrower nor a Lender Be" Journal of Money, Credit and Banking, 3, pp. 625-638. PETERSEN, M and RAJAN, R. (1995): "The effect of credit market competition on lending relationships". Quarterly Journal of Economics,110, May, pp.404-443 SAMOLYK, K. (1998): "Small Business Credit Markets: Why do we know so little about them?" FDIC Banking Review. 10, n2, pp. 14-32 SCOTT, K (1998): "Mutual funds as an alternative banking system". Journal of Institutional and Theoretical Economics, vol. 154/1 pp. 86-96. SCHMIDT, SCHMIDT, R.H., HACKETHAL, A. and TYRELL, M.: (1999): "Disintermediation and the role of banks in Europe". Journal of Financial Intermediation 8, pp.36-67 SHRIEVES R. and DHAL, D: (1995): "Regulation, recession and bank lending behavior. The 1990 Credit Crunch". Journal of Financial Services Research, 9. pp.5-30.

STRAHAN, P.E. and WESTON, J.P. (1998): "Small business lending and the changing structure of the banking industry". Journal of Banking and Finance 22, pp. 821-845

WALTER, I. (1999). The Global Assets Management Industry: Competitive Structure and Performance in Financial Markets Institutions and Instruments. Blackwell Publishers. Oxford. p.1-78

APPENDIX. PEARSON CORRELATION COEFFICIENTS FOR MODEL VARIABLES (1993-1998)

p-values in parenthesis

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Microeconomic determinants of bank lending

LNTA LNTA NB

NB

LLSS

GDP

SPR

LCMS

MFSTC

0.283** (0.000) -0.037 0.080 LLSS (0.427) (0.103) 0.036 0.041 -0.081 GDP (0.466) (0.399) (0.099) 0.148** 0.143** 0.045 SPR (0.002) (0.003) (0.334) 0.207** 0.863** 0.073 LCMS (0.000) (0.000) (0.123) -0.163** -0.379** -0.110* MFST (0.000) (0.000) (0.019) 0.062 0.815** 0.066 TA (0.184) (0.000) (0.160) -0.055 -0.540** -0.067 CTAR (0.243) (0.000) (0.155) 0.207** -0.060 0.037 CINFF (0.000) (0.239) (0.440) -0.016 -0.133** -0.009 HHIL (0.752) 0.007 (0.858) 0.137** 0.149** -0.033 MSL (0.006) (0.002) (0.508) 0.020 -0.202** -0.037 HHID (0.684) (0.000) (0.459) 0.090 0.042 -0.024 MSD (0.067) (0.397) (0.628) * statistically significant at 5 per cent (two sided) ** statistically significant at 1 per cent (two sided)

-0.046 (0.351) 0.114* (0.020) 0.009 (0.850) 0.105* (0.032) -0.069 (0.162) 0.055 (0.283) -0.081 (0.101) 0.036 (0.470) -0.009 (0.849) 0.011 (0.828)

0.071 (0.131) -0.170** (0.000) 0.019 (0.689) -0.024 (0.606) 0.105* (0.030) 0.117* (0.017) 0.004 (0.937) 0.036 (0.467) 0.053 (0.286)

-0.398** (0.000) 0.913** (0.000) -0.556** (0.000) -0.074 (0.126) -0.005 (0.919) 0.304** (0.000) 0.049 (0.322) 0.182** (0.000)

-0.389** (0.000) 0.238** (0.000) 0.071 (0.143) -0.099* (0.044) -0.268** (0.000) -0.083 (0.090) -0.260** (0.000)

PEARSON CORRELATION COEFFICIENTS FOR MODEL VARIABLES (continued) (1993-1998)

p-values in parenthesis

TA

CTAR

CINFF

HHIL

MSL

HHID

MSD

-0.589** CTAR (0.000) -0.112* -0.589 CINFF (0.020) (0.000) -0.001 0.085 -0.001 HHIL (0.989) (0.085) (0.989) 0.312** -0.048 0.312** MSL (0.000) (0.329) (0.000) 0.037 0..098* -0.077 HHID (0.455) (0.046) (0.128) 0.177** 0.018 -0.210** MSD (0.000) (0.720) (0.000) * statistically significant at 5 per cent (two sided) ** statistically significant at 1 per cent (two sided)

0.385** (0.000) 0.574** (0.000) 0.489** (0.000)

0.707** (0.000) 0.918** (0.000)

0.758** (0.000)

LNTA: Loan over total assets; NB: Number of branches (log); LLSS: Loan losses; GDP: GDP growth rate; SPR: Loan to deposits rate spread; LCMS: loan commitments (log); MFST: Mutual funds over short-term creditors; TA: Total assets (log); CATR: Capital to assets ratio; CINFF: Cost inneficiencies; HHIL: HHI for loans; MSL; Loans market share; HHID: HHI for deposits; MSD: Deposits market share.

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