Observables and Residuals: Exploring Cross-Border Differences in SME Borrowing Costs

Cross-country comparisons of average loan interest rates, often carried out using statistics provided by national and international authorities, should be accompanied by strong caveats. If underlying compositional differences in loans, borrowers or lenders are unaccounted for, claims of over/under-pricing may be unfounded. In this paper, we propose a simple methodology that compares interest rates between countries after controlling for such differences. We apply our method to loan-level data from three Irish banks lending to Small and Medium Enterprises (SMEs) in both Ireland and the UK. We find that controlling for such factors reduces the the cross-country interest rate premium significantly. We attribute any remaining interest rate “gap” to overall lending market conditions – for example, to differences in the recoverability of collateral, the level of competition among banks, the aggregate perception of risk, or banks’ expectations on the relative movements in policy rates and exchange rates between the UK and the euro area.