One of the most powerful technologies for ensuring that small firms can get an adequate
supply of credit is ‘relationship lending.’ But according to new research by Professors
Allen Berger and Gregory Udell, published in the latest issue of the Economic Journal,
the key relationship is not the relationship between the bank and the firm, but rather the
relationship between the loan officer and the firm’s owner. What’s more, this relationship in
great part rests on ‘soft’ data, such as information about character and reliability of the
firm’s owner, which may be difficult to quantify, verify and communicate through the normal
transmission channels of a banking organisation.
This has important implications for the consolidation of the banking industry. Regulatory
changes such as the ‘single market’ programme in the European Union and the Gramm-
Leach-Bliley Act in the United States allow for universal banking in which commercial
banks may be combined with other financial service companies to form even larger
financial entities with more complex managerial structures. The research suggests that:
· On the one hand, this may have a negative impact on relationship lending because it is
more difficult to transmit the soft data associated with relationship loans through the
layers of management in larger financial institutions.
· On the other hand, there may be an offsetting ‘external’ effect in which the decline in
relationship lending by the merging banks is offset by increased relationship lending by
other banks in the market. After a merger, loan officers may leave their current
employers and join an existing smaller bank in the same market or form a new bank,
taking their ‘relationship’ customers with them. This is possible because the banking
relationship resides with loan officer and not the bank.
· If the latter effect dominates, then the consolidation of the banking industry may have
little impact on the small business funding gap because of lost banking relationships.
Berger and Udell note that the issue of credit availability to small firms has garnered worldwide
concern recently. Theoretical analysis of credit rationing suggest that small firms may
be particularly vulnerable because they are often so informationally opaque. In other words,
the ‘informational wedge’ between insiders and outsiders tends to be more acute for small
companies, making the provision of external finance for these firms particularly
challenging.
As a result, small firms with attractive investment opportunities may face a funding gap
because potential providers of external finance cannot readily verify that the firm has
access to a quality project (the ‘adverse selection’ problem) or ensure that the funds will
not be diverted to fund an alternative project (the ‘moral hazard’ problem). Small firms are
also vulnerable because of their dependence on financial institutions for external funding,
as these firms do not have access to public capital markets. As a result, changes in the
banking system can have a significant impact on the supply of credit to small businesses.
One of the most powerful technologies available to reduce information problems in small
firm finance is ‘relationship lending.’ Under relationship lending, banks acquire information
over time through contact with the firm, its owner, and its local community on a variety of
dimensions and use this information in their decisions about the availability and terms of
credit to the firm.
Despite the recent academic focus on relationship lending, there is remarkably absent in
the literature a fully satisfying analysis of precisely how bank-borrower relationships work.
Berger and Udell’s study develops a model of bank lending that emphasises that the key
relationship is not the relationship between the bank and the firm, but rather the
relationship between the loan officer and the firm’s owner.
The research examines the potential effects of a number of other types of shocks to the
banking system on the supply of credit to informationally opaque small businesses,
including technological innovations, regulatory regime shifts, and changes in the
macroeconomic environment.
ENDS
Notes for Editors: ‘Small Business Credit Availability and Relationship Lending: The
Importance of Bank Organisational Structure’ by Allen N. Berger and Gregory F. Udell is
published in the February 2002 issue of the Economic Journal. Berger is a Senior
Economist at the Board of Governors of the Federal Reserve System, Washington, DC
20551 and Wharton Financial Institutions Centre, Philadelphia, PA 19104; Udell is at the
Kelley School of Business, Indiana University, Bloomington, IN 47405.
For Further Information: contact Allen Berger on +1-202-452-2903 (fax: +1-202-452-
5295; email: aberger@frb.gov); Greg Udell via email: gudell@indiana.edu); or RES Media
Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email:
romesh@compuserve.com).