Bank Loan Markups and Adverse Selection

How does adverse selection affect the interest rates on bank loans? Using corporate bank loan data, we create a measure of markup using the internal measures of risk banks report to the Federal Reserve. Our risk-adjusted measure of markup does not predict the subsequent performance of loans, while a measure excluding banks’ private risk assessments strongly predicts performance. Consistent with theories of asymmetric information in which lower concentration increases the information rents banks extract, we find that markups are higher in less concentrated regions, among firms that are more subject to asymmetric information and when firms stay with their existing banks. Finally, higher local markups are associated with lower loan volume and higher levels of collateralization. Our findings suggest that adverse selection drives markups, loan volume and lending standards.