A Multistage Model of Loans and the Role of Relationships

The goal of this paper is to further our understanding of how relationships work in the borrower-lender interaction for a loan. A practical implication emerging from classical studies is that lenders overcome the problem of information asymmetry by collecting information about the borrowers through close relationships and using this information in credit approval and loan rate decisions. We test this implication in our paper using a robust sample selection methodology and data from the 1998 Survey of Small Business Finances. Our empirical model accounts for the entire fabric of the loan granting process within a unified framework, including (1) a borrower's decision to apply to a financial institution for a loan, (2) the financial institution's decision to approve the application for a loan, and (3) the loan rate the financial institution chooses for the borrower conditional on approving the loan. Our model also explicitly includes the analysis of discouraged borrowers (i.e., those that do not apply for loans because they believe they will be rejected). We find that relationships matter only in a borrower's decision whether to apply for a loan and in the loan approval/rejection decision by the financial institution. Relationships, however, are not important in determining the loan rate associated with the approved loan once the sample selection bias in the loan process is appropriately accounted for. Our conclusions remain robust to both quot;relationship-drivenquot; loans and to the relative size of the business