Bank pricing of corporate loans, short versus long maturities

From the sovereign debt crisis to the end of 2019, bank credit to Portuguese firms fell, spreads on new loans decreased and banks reported an increase in competition. The combination of these dynamics raises concerns that banks were underpricing loans. In a bid to remain competitive, banks may have offered loan spreads below the level needed to compensate banks’ equity holders for bearing risk.

This paper studies whether the spreads on new corporate loans are sufficient to cover loans’ expected credit losses, operating costs and capital costs. The analysis covers bank loans originated between September 2018 and December 2019 by the largest banks operating in Portugal.

Results suggest that banks’ equity holders are earning a return higher than an estimated cost of equity of 8 percent in the short-run. In the medium to long-run, however, loans are underpriced. Banks’ equity holders stand to earn a return lower than the cost of equity, especially if banks keep on originating loans as in the sample period.

Underpricing in the medium to long-run is reduced if we take into account only the subsample of loans originated during 2019 (see Figure). Results also show that loan underpricing is linked to loans with maturity longer than a year, loans to the construction, real estate, and transportation and storage sectors, and loans to high credit risk borrowers.

Click here to go to the paper by Márcio Mateus and Tiago Pinheiro.