Does Transparency about Banks’ Lending Costs Lower Firms’ Borrowing Costs? Evidence from India

Publication: Forthcoming in Journal of Accounting and Economics 

Synopsis: 

Imagine if you could know exactly what it costs your bank to lend you money. Sounds like a good deal, right? That’s precisely what happened in India when the Reserve Bank of India (RBI) decided to shake things up. Before 2010, banks in India used to follow the prime lending rate system, where they had a lot of leeway in deciding interest rates. But there was a catch – banks weren’t really transparent about how they set those rates, leaving borrowers in the dark. 

This all changed when the RBI introduced a new rule requiring banks to switch to a cost-based benchmark interest rate system, also known as the base rate. Under this system, banks had to disclose the real costs they incur, including their interest costs, overheads, and profit margins. No more hidden charges, no more mysterious calculations – everything was audited by RBI. 

This study dives into what happened next. The findings reveal that that this new level of transparency led to a significant drop in the interest rates that businesses were paying. Why? Well, when banks were forced to reveal their costs, the competitive landscape changed. Rival banks could see where the big profits – what we call “relationship rents” – were coming from and started offering better deals to win over customers. This made it harder for banks to charge those high rates. The impact was pretty substantial. Not only did borrowing costs go down, but businesses started borrowing more and, as a result, invested more in their growth. It’s a win-win: companies got cheaper loans, and the economy got a boost from increased investments. 

What’s particularly interesting is how this transparency levelled the playing field. Before the change, banks with close ties to borrowers could charge a premium just because they had the inside scoop on their clients’ needs. But once everyone could see the actual costs, these “relationship” banks had to drop their rates to stay competitive. The result? More options for borrowers and lower costs all around. 

In short, this study shows that a little transparency can make a big difference. By pulling back the curtain on bank lending costs, the RBI’s move not only made loans cheaper for businesses but also spurred more investment and economic activity. It’s a great example of how smart regulation can benefit both businesses and the broader economy.