Small Business Credit Availability and Relationship Lending : The Importance of Bank Organizational Structure

Changes in the economic environment where banks and small businesses operate have raised questions about the availability of credit to small businesses. Small businesses have fewer alternatives to external finance than do large companies. A brief overview of small firm financing is offered, emphasizing the important role of financial institutions in providing external finance to small businesses. Lending is categorized into four separate technologies: financial-statement lending, asset-based lending, credit scoring, and relationship lending; lending is compared with the other technologies in terms of how they are implemented and whom they are targeted to. Next, organizational issues associated with structuring the lending function are examined, and a simple model of bank-lending is proposed. The model is used to examine the impact of shocks to the economic environment in which banks and small businesses function on the availability of credit to small business, including technical innovationssuch as credit scoring, regulatory regime shifts such as toughened bank supervision, shifts in competitive conditions such as banking industry consolidation, and changes in the macroeconomic environment such as monetary policy shocks. The proposed model identifies three key features of relationship lending: (1) it depends on 'soft' information about the firm, its owner, and the local community; (2) the loan officer has the most important relationships with the firm, owner and community; and (3) an agency problem appears between the loan officer and bank management because of the soft nature of relationship information. The joint solution to these problems helps assess the capacity of the bank to deliver relationship lending. (CBS)