The central question addressed in this paper is why most loan pricing agreements between banks and their commercial customers involve additive rather than multiplicative markups over the base lending rate. It is argued that banks generally prefer additive pricing because the real value of the premiums moves inversely with inflation. Therefore this pricing formula provides an automatic partial inflation hedge for banks. Most borrowers who hold long positions in nominal assets also prefer this formula for the same reason. However, some borrowers who hold net short positions in nominal assets prefer multiplicative pricing. Banks provide them with such a form of pricing in exchange for appropriate compensation. Supporting empirical evidence is provided.
Bibliographical noteFunding Information:
*Financial support from the Zimmerman Foundation for Research in Banking and Finance is gratefully acknowledged. We are indebted to Stuart Greenba~'~ ~d Paul Wachtel for helpful comments on an earlier draft, and we are grateful to two anonymous referees for helpful comments and suggestions. ~The main issue addressed in this literature ~z whether or not compensating balances are the result of rational bank behaviour. See Wrightsman (1973), Kolodny and Seeley (1977) and Lain and Boudreaux (1980) for summaries and review of the main arguments. 2For a review see James (1982) and Santomero (1983).
ASJC Scopus subject areas
- Economics and Econometrics