Rules versus Discretion in Loan Rate Setting
Loan rates for seemingly identical borrowers often exhibit substantial dispersion. This paper investigates the determinants of the dispersion in interest rates on loans granted by banks to small and medium sized enterprises. We associate this dispersion with the loan officers’ use of “discretion” in the loan rate setting process. We find that “discretion” is most important if: (i) loans are small and unsecured; (ii) firms are small and opaque; (iii) the firm operates in a large and highly concentrated banking market; and (iv) the firm is distantly located from the lender. Consistent with the proliferation of information-technologies in the banking industry, we find a decreasing role for “discretion” over time in the provision of small credits to opaque firms. While widely used in the pricing of loans, “discretion” plays only a minor role in the decisions to grant loans.