A theory of banks' industry expertise, market power, and credit risk

The author analyzes banks' incentives to acquire expertise in judging the creditworthiness of borrowers in an industry with uncertain business conditions. The analysis shows that industry expertise enables banks to extract rents proportional to their exposure to industry-specific credit risk. This exposure is in turn determined by the number of banks aiming to focus on lending to an industry. In equilibrium, the industry receives funding from a limited number of banks with industry expertise, as well as from a competitive fringe of financiers without such expertise. The equilibrium yields testable predictions about the concentration of bank lending to an industry, and about the correlation between this concentration and the recovery rates, default rates, and interest rates of bank loans.