In 2001, government guarantees for savings banks in Germany were removed following a law suit. We use this natural experiment to examine the effect of government guarantees on bank risk taking, using a large data set of matched bank/borrower information. The results suggest that banks whose government guarantee was removed reduced credit risk by cutting off the riskiest borrowers from credit. At the same time, the banks also increased interest rates on their remaining borrowers. The effects are economically large: the Z-Score of average borrowers increased by 7% and the average loan size declined by 13%. Remaining borrowers paid 57 basis points higher interest rates, despite their higher quality. Using a difference-in-differences approach we show that the effect is larger for banks that ex ante benefited more from the guarantee. We show that both the credit quality of new customers improved (screening) and that the loans of existing riskier borrowers were less likely to be renewed (monitoring), after the removal of public guarantees. Public guarantees seem to be associated with substantial moral hazard effects.JEL Classification: G21, G28, G32

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.

Hidden gems and borrowers with dirty little secrets: investment in soft information, borrower self-selection and competition ECB Working Paper, No. 1555 Provided in Cooperation with: European Central Bank (ECB)Suggested Citation: Gropp, Reint; Gruendl, Christian; Guettler, Andre (2013) : Hidden gems and borrowers with dirty little secrets: investment in soft information, borrower self-selection and competition, ECB Working Paper, No. 1555, European Central Bank (ECB) We focus on the difference between firms with positive soft information and firms with negative soft information. Recent theoretical models (Hauswald and Marquez, 2006;Inderst and Mueller, 2007) suggest that firms with positive soft information would tend to self-select to relationship banks, because relationship banks can take the positive private signal into account in the lending decision. This creates an Akerlof-type adverse selection problem, in which transaction banks tend to receive applications from borrowers with on average negative soft information. In response, transaction banks may apply a negative adjustment to the rating of all their loan applicants. However, if they do, even borrowers with slightly negative private information may be better off obtaining a loan from a relationship bank, resulting in an even worse pool of loan applicants with respect to the private signal and so forth. Ultimately, in the absence of any offsetting factor, transactions banks would no longer participate in the market for small business loans and some positive NPV firms may no longer receive credit. The selection effect may explain why banks ultimately specialize in either relationship or transaction banking.Furthermore, theory would predict that there are interaction effects with the degree of interbank competition. In particular, Boot and Thakor (2000) argue that there are two effects. When competition is introduced, banks' marginal rents from relationship lending are smaller and each bank thus reduces its investments in soft information. However, competition affects the bank's profits from both relationship and transaction lending asymmetrically. A relationship orientation helps to partially insulate the bank from pure price competition, so that an increase in competition from other banks hurts the bank's profits from transaction lending more than its profits from relationship lending. Thus, increased competition between banks may encourage banks to shift from transaction to relationship lending.We use a matched bank-borrower dataset of German savings banks to test these predictions.These banks provide an ideal laboratory, as they compete with pure transaction banks, such as 2 Deutsche Bank and with pure relationship banks, such as the large number of extremely small cooperative banks in Germany. At the same time, there is sufficient variation within the savings bank sector in the degree to which banks incorporate soft information in their lending decisions.Most importantly, the dataset allows us to construct a proxy for the case when the private no...

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