Asymmetric information and price competition in small business lending Ming-Hua Liu a,c , Dimitris Margaritis b,⇑ , Alireza Tourani-Rad c a Faculty of Business Administration, University of Macau, Macau, China b The University of Auckland Business School, Auckland, New Zealand c Faculty of Business & Law, Auckland University of Technology, New Zealand article info Article history: Received 9 December 2009 Accepted 17 January 2011 Available online 2 February 2011 JEL classification: G21 E43 Keywords: Lending rate Cost of funds Small and medium enterprises Information asymmetry Error-correction models abstract This paper examines the relationship between bank lending rates and their cost of funds in New Zealand. Our results show that on average mortgage rates respond more quickly to changes in the cost of funds than base business lending rates. We also find an asymmetry in the initial (short-run) response of banks to changes in funding costs; in particular, our results show banks adjust mortgage rates downwards fas- ter than upwards. The speed to which lending rates revert back to their equilibrium relationship with funding costs varies across the lending markets. We find the adjustment speed is faster when mortgage rates are below equilibrium, whereas it is slower when business lending rates are above long-run levels in relation to funding costs. Our analysis suggests that banks prefer the plain-vanilla type of lending such as mortgages in comparison to small business lending consistent with asymmetric information associ- ated with business loans. Ó 2011 Elsevier B.V. All rights reserved. 1. Introduction During the recent global financial crises, while financial institu- tions in the US, UK and Continental Europe were fighting for their survival due to massive exposures to sub-prime mortgages and re- lated mortgage derivatives such as CMOs, banks in New Zealand (and Australia) remained relatively profitable in the face of signif- icant external shocks (see Table 1). In fact, out of the 20 or so banks rated AA in the world in 2009, four banks come from Australia who also control about 90% of banking assets in New Zealand. The contrasting fortunes of the major Australasian banks when compared with those of financial institutions in many other coun- tries have put the spotlight on the lending behavior of these banks, in particular in New Zealand. A main concern is the issue of whether banks have been too slow to pass on reductions in official interest rates and/or cost of funds to borrowers and whether the Australian-controlled banks were profiting at the expense of their New Zealand customers and the economy. Central to the public policy debate has been the issue of whether high concentration in the banking industry compromises the degree of effective com- petition between banks. 1 During the period July 2008 to May 2009, the official cash rate (OCR) in New Zealand, an overnight policy rate similar to the fed- eral funds rate in the United States, was reduced drastically from 8.25% to 2.5% as the economy entered into a recession. While banks have passed on, to a large extent, interest rate cuts to mortgage borrowers, much less was passed onto business customers. For example, the average floating mortgage rate went down from 10.9% to 6.4% (a reduction of 450 basis points), but the base busi- ness lending rate decreased from 12.2% to 9.8% (a mere reduction of 240 basis points). Not only were business lending rates kept high, the amount of business lending has also been reduced as banks tighten their lending standards when the economy deterio- rates and default rates increase. As businesses, especially the smaller ones are the biggest sources of employment in New Zealand, high business lending rates and/or lack of credit may result in significant job losses. Against this back- ground, in a rare move on 9 June 2009, the Finance and Expenditure Select Committee of the New Zealand Parliament issued a report criticizing banks in New Zealand for failing to pass on interest rate cuts. The report states that it is ‘‘vital that banks neither insulate their profit margins nor charge excessively high interest rates at the expense of the real economy and taxpayers.’’ Senior government officials and civil servants have issued stern warning to banks regarding the sluggish pass-through of interest rate cuts. For example, the Finance Minister, Bill English, raised concern that banks were slow in dropping mortgage rates, but said 0378-4266/$ - see front matter Ó 2011 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2011.01.022 ⇑ Corresponding author. Tel.: +64 9 373 7599x87181; fax: +64 9 373 7406. E-mail addresses: mhliu@umac.mo (M.-H. Liu), d.margaritis@auckland.ac.nz (D. Margaritis), tourani@aut.ac.nz (A. Tourani-Rad). 1 See the Report of the Parliamentary Inquiry into Banking, November, 2009 (http:// img.scoop.co.nz/media/pdfs/0911/report_of_the_parliamentary_banking_inquiry.pdf). Journal of Banking & Finance 35 (2011) 2189–2196 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf