When banks become crowded within a lending market, the familiar logic of supply and demand begins to unravel. In most markets, an increase in suppliers would normally drive prices down, benefiting consumers through greater competition. Lending, however, appears to follow a different set of rules. New research shows that as the number of banks operating in a local market rises, borrowers may actually face higher costs rather than lower ones, challenging long-held assumptions about competition in financial services.

The research finds that a greater density of banks leads to higher loan prices, measured through interest rates. Specifically, for every six additional banks operating within a county, average interest rates increase by around seven basis points. While that figure may appear modest at first glance, it can translate into meaningful additional costs for large loans and long repayment periods. The finding runs directly against the intuitive idea that more choice among lenders should naturally result in cheaper credit.

This counterintuitive outcome emerges from how banks assess and manage risk. Lending decisions are shaped not only by observable financial data but also by how much private information a bank has about a borrower. Some banks are better than others at screening applicants, either because of superior analytical tools or because they have deeper relationships with local firms. When one bank approves a borrower that others have rejected, it can trigger concerns that negative information has been missed.

These concerns intensify as the number of banks in a market increases. In a crowded environment, winning a borrower may feel less like a success and more like a warning sign. Banks may worry that competitors uncovered unfavourable information that they themselves failed to detect. To compensate for that uncertainty, lenders raise interest rates as a form of protection against potential default. Rather than pricing loans aggressively, they adopt a more cautious stance.

This dynamic closely resembles what economists describe as the “winner’s curse”. In highly competitive auctions, the winning bidder often pays more than the asset is truly worth because they were the most optimistic participant. In lending markets, securing a borrower in a sea of competitors can similarly suggest that the lender has underestimated the borrower’s risk. The higher interest rate becomes a buffer against the possibility that the loan turns out to be a bad bet.

Competition also affects the volume and quality of lending. As the number of banks grows, total lending increases significantly, but so does risk. Higher lending volumes are accompanied by a greater probability of default, indicating that banks are extending credit more broadly and to riskier borrowers. In addition, repeated borrowing from the same bank can result in higher interest charges, as the lender gains deeper insight into the borrower’s true risk profile and adjusts pricing accordingly.

Taken together, these findings point to a surprising conclusion: more competition is not always better for borrowers. In more concentrated banking markets, lenders may feel less exposed to hidden information and therefore offer more favourable rates. This has important implications for regulators, who often promote competition by discouraging mergers or forcing banks to divest branches. It also offers practical insight for small businesses, which may benefit from considering bank concentration when deciding where to operate or seek financing.

More information: Cesare Fracassi et al, Adverse Selection in Corporate Loan Markets, Journal of Finance. DOI: 10.1111/jofi.70011

Journal information: Journal of Finance Provided by University of Texas at Austin