Does Discretion in Lending Increase Bank Risk? Borrower Self-Selection and Loan Officer Capture Effects

In this paper we analyze whether discretionary lending increases bank risk. We use a panel dataset of matched bank and borrower data. It offers the chief advantages that we can directly identify soft information in banks’ lending decisions and that we observe ex post defaults of borrowers.Consistent with the previous literature, we find that smaller banks use more discretion in lending. We also show that borrowers self-select to banks depending on whether their soft information is positive or negative. Financially riskier borrowers with positive soft information are more likely to obtain credit from relationship banks. Risky borrowers with negative soft information have the same chance to receive a loan from a relationship or a transaction bank. These selection effects are stronger in more competitive markets, as predicted by theory. However, while relationship banks have financially riskier borrowers, ex post default is not more probable compared to borrowers at transaction banks. As a consequence, relationship banks do not have higher credit risk levels. Loan officers at relationship banks thus do not use discretion in lending to grant loans to ex post riskier borrowers.