Loan Pricing in Interest Rate Liberalization in China

Abstract

In order to find how the process of interest rate liberalization influences the pricing strategy of dominant lenders in China’s loan market and their mark-up power, I establish a pricing model to examine the effect of level of discretion in an oligopoly loan market on the incumbent lenders’ entry-deterrence pricing strategy. In my theoretical models, I find two critical propositions: first, with perfect information, the mark-up power of the interest rate in the primary market decreases as the level of discretion in price-setting increases. This effect is mitigated, however, by moral hazard. Second, with the existence of adverse selection, an increase in the level of discretion indicates that the incumbent lenders can have more room to set the pool-pricing interest rate in the primary market. Moreover, I provide empirical evidence for decreasing mark-up pricing in China’s loan market as loan rate liberalization completes, consistent with the prediction of my model.