On the profitability and cost of relationship lending

We provide evidence on the costs and profitability of relationship lending by banks. We derive bank-specific measures of loan rate smoothing for small business borrowers in response to exogenous shocks to their credit risk and to interest rates, and then estimate cost and profit functions to examine how smoothing affects bank costs and profits. Our results suggests that, in general, loan rate smoothing in response to a credit risk shock is not part of an optimal long-term contract between a bank and its borrower, while loan rate smoothing in response to an interest-rate shock is. (C) 1998 Elsevier Science B.V. All rights reserved.