Relationship Loans and Information Exploitability in a Competitive Market: Loan Commitments vs. Spot Loans

Despite the numerous benefits of loan commitments, only 79% of the commercial and industrial loans are made under commitment. I show that two factors limit the use of loan commitments. First, because banks commit themselves to lend, they carry costly liquidity reserves to meet their obligations. Due to liquidity costs, the interest rate on commitment loans is high relative to spot loans. Second, high interest rates trigger moral hazard. If the bank expects a profitable relationship in the future, it can absorb a portion of the liquidity costs to reduce the interest rate and attenuate moral hazard. If not, the borrower cannot get a loan commitment.