ABSTRACT OF DISSERTATION. Jiang Hou. The Graduate School. University of Kentucky

Transcription

1 ABSTRACT OF DISSERTATION Jang Hou The Graduate School Unversty of Kentucky 2006

2 A MEASUREMENT OF THE SMALL BUSINESS CREDIT GAP AND THE USE OF CREDIT SCORING BY SMALL FINANCIAL INSTITUTIONS ABSTRACT OF DISSERTATION A dssertaton submtted n partal fulfllment of the requrements for the degree of Doctor of Phlosophy n the College of Agrculture at the Unversty of Kentucky By Jang Hou Co-Drectors: Dr. Jerry. R. Skees, Professor of Agrcultural Economcs and Dr. Erc Scorsone, Assocate Professor of Agrcultural Economcs Lexngton, Kentucky 2006 Copyrght Jang Hou 2006

3 ABSTRACT OF DISSERTATION A MEASUREMENT OF THE SMALL BUSINESS CREDIT GAP AND THE USE OF CREDIT SCORING BY SMALL FINANCIAL INSTITUTIONS Technologcal and regulatory changes and the consoldaton trends of the last two decades are factors affectng the credt stuaton for small busnesses. Ths dssertaton begns wth a theoretcal framework summarzng potental factors that may lead to credt constrants for small busnesses. An emprcal model s used to measure the magntude of the possble credt gap. Based on ndustral economc theory, small fnancal nsttutons can play a role n reducng ths credt gap. Because of the hgher rsk of small busness customers, sustanablty s of prmary concern for small fnancal nsttutons. As an nnovatve soluton, credt scorng for use by small fnancal nsttutons s then ntroduced and ts effectveness s demonstrated. A theoretcal background and general characterstcs of the credt market, such as credt ratonng, are frst presented. Next, the phenomenon of less credt supply n rural areas or poor communtes s analyzed, as well as how consoldaton trends n the bankng ndustry can contrbute to the credt gap. Ths dssertaton then tests emprcally whether credt constrants facng small busnesses do exst. Possble credt constrants are quantfed usng the Call Reports of the 1990s and data from The Natonal Survey of Small Busness Fnance, The potental credt gap s determned by the dfference between the expected debt level and the actual debt level. Small fnancal nsttutons are usually vewed as havng the nformatonal advantage and organzatonal flexblty to lend to small busnesses. However, specalzng n small busnesses loans can brng hgh fnancal rsk to small fnancal nsttutons because of the hgher default rsk of small busnesses. The practce of credt scorng s ntroduced as a soluton. Clent data of one small fnancal nsttuton, Communty Ventures Corporaton (CVC) of Kentucky, are used to test the effectveness of the credt-scorng model.

4 The results of the tests on small-busness lendng presented n ths dssertaton show that: Frst, a credt gap does exst for small-busness frms and ts magntude s quantfed; Second, credt scorng can help small fnancal nsttutons by effectvely revealng the characterstcs of unqualfed customers, guaranteeng the sustanablty of small fnancal nsttutons and an expanson of ther servces to more small busness customers. Keywords: Credt Gap, Credt Rsk, Credt Scorng, Informaton Asymetry, Small Busness Lendng, Jang Hou (Date)

5 A MEASUREMENT OF THE SMALL BUSINESS CREDIT GAP AND THE USE OF CREDIT SCORING BY SMALL FINANCIAL INSTITUTIONS By Jang Hou Co-Drector of Dssertaton Co-Drector of Dssertaton Drector of Graduate Studes (Date)

6 RULES FOR USE OF DISSERTATION Unpublshed dssertatons submtted for the Doctoral degree and deposted n the Unversty of Kentucky Lbrary are as a rule open for nspecton, but to be used only wth due regard to the rghts of the authors. Bblographcal references may be noted but quotatons or summares of parts may be publshed only wth the permsson of the author, and wth the usual scholarly acknowledgements. Extensve copyng or publcaton of the dssertaton n whole or n part requres also the consent of the Dean of the Graduate School of the Unversty of Kentucky. A Lbrary whch borrows ths thess for use by ts patrons s expected to secure the sgnature of each user. Name and Address Date

7 DISSERTATION Jang Hou The Graduate School Unversty of Kentucky 2006

8 A MEASUREMENT OF THE SMALL BUSINESS CREDIT GAP AND THE USE OF CREDIT SCORING BY SMALL FINANCIAL INSTITUTIONS DISSERTATION A dssertaton submtted n partal fulfllment of the requrements for the degree of Doctor of Phlosophy n the College of Agrculture at the Unversty of Kentucky By Jang Hou Lexngton, Kentucky Co-Drectors: Dr. Jerry. R. Skees, Professor of Agrcultural Economcs and Dr. Erc Scorsone, Assocate Professor of Agrcultural Economcs Lexngton, Kentucky 2006 Copyrght Jang Hou, 2006

9 Table of Contents Lst of Tables... v Lst of Fgures... v CHAPTER 1 INTRODUCTION OBJECTIVES AND ORGANIZATION OF THE DISSERTATION... 3 CHAPTER 2 THEORETICAL BACKGROUND MARKET FAILURE FOR SMALL-BUSINESS LENDING I: INFORMATION ASYMMETRY ACROSS CREDIT MARKETS Supply-and-Demand Prncples for Fnancal Intermedares Characterstcs of the Credt Market Specal Market Partcpants n Small-Busness Lendng MARKET FAILURE FOR SMALL-BUSINESS LENDING II: SPATIAL INFORMATION ASYMMETRY ACROSS REGIONS The Vcous Cycle of Market Falure Necessty of Government Interventon MARKET FAILURE FOR SMALL-BUSINESS LENDING III: A MORE CONSOLIDATED MARKET STRUCTURE Consoldaton Trends n the Credt Market The Organzatonal Dseconomy of Consoldated Banks The GHM (Grossman, Hart, and Moore) Paradgm and More The Role of Small Fnancal Insttutons CHAPTER 3 MEASURING THE SMALL BUSINESS CREDIT GAP THE NATIONAL SURVEY OF SMALL BUSINESS FINANCE (NSSBF) CALL REPORTS DATA FINANCING PATTERNS STUDY BASED ON THE NSSBF, The Users of Credt Dstrbutons of Outstandng Debt Used by Small Frms Debt-Asset Structure of Small Busness Frms ANALYZING FINANCING TRENDS FROM THE CALL REPORTS DATA Consoldaton Trends Shftng the Lendng Emphass Market Share Changes n Small-Busness Lendng PRELIMINARY CONCLUSIONS CHAPTER 4 QUANTIFICATION OF THE CREDIT GAP THE EMPIRICAL MODEL DATA AND VARIABLES ESTIMATION RESULTS Quantfcaton of the Credt Gap for Small Busnesses CHAPTER 5 CREDIT-SCORING PRACTICES THAT CAN HELP SMALL FINANCIAL INSTITUTIONS SERVE SMALL BUSINESS FIRMS THE ROLE AND ADVANTAGES OF SMALL FINANCIAL INSTITUTIONS THE THREAT TO SMALL BANKS TRYING TO RETAIN THEIR LENDING NICHE v

10 5.3 A CONCEPTUAL FRAMEWORK (USING AN SBA LENDING INTERMEDIARY AS AN EXAMPLE) CASE STUDY: CREDIT SCORING IN ONE SMALL FINANCIAL INSTITUTION, COMMUNITY VENTURES CORPORATION (CVC) OF KENTUCKY Background of CVC of Kentucky The Busness Functon of CVC of Kentucky Small Busness Ownershp Program Homeownershp Programs Busness Expanson Program Credt Rsk Management Technques Group Lendng Dynamc Incentves Regular Repayment Schedule Tranng Credt Scorng as a Rsk Management Tool Prevous Credt-Scorng Research Pros and Cons of Credt Scorng Models of Credt Scorng Emprcal Analyss: Estmatng a Credt-Scorng Model for an SBA Mcroloan Intermedary (CVC of Kentucky) Data and Varables Statstcal Test of Varables Regresson Results Estmates Comparson Margnal Effect Analyss Statstcal Effectveness Test Concluson CHAPTER 6 SUMMARY AND CONCLUSIONS SUMMARY OF RESEARCH CONCLUSIONS LIMITATIONS OF THE ANALYSIS AND SUGGESTIONS FOR FURTHER RESEARCH APPENDIX 1 SAMPLE SELECTION PROBLEMS AND CORRECTION METHODOLOGY APPENDIX 2 MODEL ILLUSTRATING THE REALITY OF SMALL-BUSINESS LENDING IN THE UNITED STATES REFERENCES TO THE APPENDICES BIBLIOGRAPHY VITA 100 v

11 Lst of Tables Table 3.1 The 1998 Natonal Survey of Small Busness Fnance (Overvew of Content) 24 Table 3.2 Percentage of Small Frms Usng Credt by Organzaton Scale Table 3.3 Trends of Banks Market Share by Bank Sze Table 3.4 Percentage of Small-Busness Loans to Total Loans Table 3.5 Bank s Market Share of Small Busness Loans (Categorzed by Asset) Table 4.1 Frm, Geographc, Owner, and Relatonshp Characterstcs of Small Busnesses Table 4.2 Probt Estmates: Whether Frms Are Credt Constraned Table 4.3 Probt Estmates: Whether Frms Are n Debt Table 4.4 Determnaton of the Debt Levels of Small Frms Table 4.5 Credt Gap Estmaton Categorzed by Industry, Organzatonal Type, Sze, and Geographc Areas Table 5.1 Varables Descrpton Table Table 5.2 Descrptve Statstcs for the CVC Data Table 5.3 Test Result for Multcollnearty of Independent Varables Table 5.4 Regresson Result of Logstc Model Table 5.5 Regresson Results of the Probt Model Table 5.6 Estmated Repayment Probablty That Changes as Interest Rates Vary Table 5.7 Margnal Effect Analyss of Varables v

12 Lst of Fgures Fgure 1.1 Informaton Asymmetry n Small Frm Lendng Error! Bookmark not defned. Fgure 2.1 Supply and Demand of Fnancal Intermedares... 7 Fgure 2.2 Determnaton of a Lender s Equlbrum Interest Fgure 2.3 Clents of Small-Busness Lendng (Workng Poor) Fgure 3.1 Types of Tradtonal and Non-Tradtonal Credt Used by Small Busness Frms (%) Fgure 3.2 Small Busness Loans Outstandng by Bank Sze Fgure 5.1 CVC Servce Dstrbuton n Kentucky Fgure 5.2 Dagram of the Credt-Scorng Process Fgure 5.3 Dstrbuton of Interest Rates of Loans Fgure 5.4 Dstrbuton of the Income Level of Borrowers Fgure A.2.1 Relatonshp of Small Busness Frms, Small Fnancal Insttutons, and Government Fgure A.2.2. Interest Rate Charged n a Small-Busness Lendng Insttuton v

13 Chapter 1 Introducton Small busnesses n the Unted States are regarded as a means to economc opportunty and nnovaton, and as a source for the naton s economc growth. Most U.S. busnesses are small- and medum-szed frms. Accordng to Internal Revenue Servce 2001 data, there were 16 mllon frms n non-farm ndustres. Usng a sales value of less than US$10 mllon as the crteron for a small busness frm, more than 99 percent of busnesses n the Unted States are fnancally small (IRS, 2001). One of the most mportant factors for the survval and growth of a busness frm s ts ablty to rase fnancal captal. The Natonal Survey of Small Busness Fnance (NSSBF), 1998, ndcates that small busnesses rely heavly on fnancal ntermedares, especally commercal banks. In the past few decades, there have been great changes n the bankng ndustry, ncludng regulaton by authortes and the consoldaton of banks. Approxmately 8,000 bank merged between 1980 and 1998, nvolvng almost $2.4 trllon n acqured assets (Stephen, 2000). Such trends n the fnancal sector rase concerns about the fnancal resources of small busnesses because small commercal customers may seem less attractve to fnancal ntermedares (Berger, 1995; De Young et al., 2003). Small-busness lendng has the general characterstcs of other types of lendng n the credt market. Demand, supply-sde, and market structure determne quanttes, prce, and other terms of credt agreements, as well as the ablty of certan borrowers to obtan a loan. On the demand-sde, busness owners wll consder the proftablty of a frm s prospects and nternal fnancng solutons. If a project s proftable, gven the costs of loans, a frm wll borrow; the cost can nclude contracted nterest, pledged collateral, or guarantees, etc. On the supply-sde, lenders wll balance the return on the nterest wth the expected rsk level. The proftablty of a gven loan relates to the prospects of the borrowng frm and the condtons of ts balance sheet. It s also assocated wth assessng and montorng the cost of the rsk. The establshment of mechansms to screen and montor loans wll ncrease the transacton costs for such loans. Fnancng condtons for small busness frms are also affected by structural characterstcs and cyclcal condtons n loan markets. The compettve structure of busness loan markets means there are more credt alternatves. Small busness frms are 1

14 lkely to obtan better credt terms n a hghly compettve market. But small busness frms are consdered most vulnerable to the changng condtons over the busness cycle. Economc downturn can depress a frm s property values, make ts ncome prospects less certan, and hnder ts access to loans Accordng to the neoclassc theory of nvestment, a frm has unlmted fund opportuntes snce fnancal markets are perfect. That means nternal and external funds are perfect substtutes under the condtons that have no transacton costs or nformaton costs (Modglan and Mller, 1958). A frm could ether use ts own equty or borrow from the credt market at some nterest to support ts busness. As a result, a credt gap between demand and supply does not exst. However, that concluson s based on the assumpton that lenders always have the same nformaton about the proftablty and rsk of projects as borrowers do. Such a concluson can hardly be vald because n most cases an asymmetrc nformaton condton does exst between lenders and borrowers. A substantal amount of lterature suggests that the reducton of asymmetrc nformaton s at the heart of the fnancal ntermedaton process (e.g., Damond, 1984; Boot 2000). Thus, nformaton economcs wll be used as the man theoretcal nstrument to explan the potental gap n the small busness frms credt demand. However, ths does not exclude other theores, such as, many small busness frms do not seem to have enough credt, but do not face credt gap problems because owners are satsfed wth ther extant operatng scale and do not want to borrow more. To test ths, a further emprcal model wll be bult to fnd whether a credt gap exsts n dfferent categores of small busnesses. Smlar to other commercal loans, nformaton asymmetres between lenders and borrowers may lead to credt ratonng, wth the result that some demands cannot be covered. Snce small busness frms often lack standard accountng procedures and other means to demonstrate the qualty of ther busness methods, nformaton asymmetry problems can be more serous for small busnesses than for ther larger counterparts. If a busness s n ts early or small stages, the busness rsk may be more sgnfcant than t would be for a mature or larger busness, and banks wll be more reluctant to lend to them. Another factor s the consoldaton trends n the bankng ndustry has resulted n more large banks that, due to the dseconomy of scale, often do not have the flexblty to 2

15 lend small loans to small busnesses. Fgure1.1 s a model that llustrates the nformaton asymmetry n small-busness lendng. Fgure 1.1 Informaton Asymmetry n Small Frm Lendng Industry Trends Concentraton, Centralzaton Credt Scorng, Term Lendng Small Frms (Agent) Problems: Fnancal Navety Lttle Track Record Collateral Requrement Hgher Rsk Informaton of project Advance of Funds Provders (Prncpal) Problems: Desred Rsk-Return Hgher Screenng Cost Hgher Montorng Cost Reject Accept Informaton Asymmetry and Related Market Falures Source: Lean and Tuck, Objectves and Organzaton of the Dssertaton Ths dssertaton tests whether credt constrants facng small busnesses really do exst and nvestgates whether nnovatons n the fnancal market, such as credt scorng, could help small fnancal nsttutons manage default rsk, thereby relaxng such credt constrants for small busnesses. Thus, by a theoretcal demonstraton and emprcal study of small-busness lendng, ths dssertaton examnes the followng ssues: 1. Whether or not a credt gap exsts for small-busness lendng, by quantfyng the magntude of the fnance demand and supply for small busness owners; and 3

16 2. Can credt scorng help small lendng nsttutons control the default rsk from small-busness lendng? The dssertaton frst examnes the economc theory underlyng the credt market wll be presented, revealng and explanng the possble credt constrants that affect small busnesses, such as credt ratonng due to nformaton asymmetry. Informaton asymmetry also occurs across regons, e.g., n less developed areas, where small busnesses may be found to be more credt constraned due to a lower number of transactons n these areas. Also, structural changes to the bankng ndustry, such as the consoldaton and acqustons of the last two decades, are other mportant factors that lmt the credt sources of small busness frms. Second, emprcal models wll be establshed to analyze the small busness data to determne whether some busness frms are experencng constraned credt stuatons or not, and how large the credt gap between credt demand and supply s, n other words, to quantfy the dfference between the expected value of debt levels and actual debt levels. Data from the Call Reports of the 1990s (data from fnancal nsttutons the supply-sde of credt) and data from The Natonal Survey of Small Busness Fnance, 1998 (nformaton from small frms the demand-sde of credt) are the two man descrptve statstcal sources used to show how trends n the credt market have affected the credt condtons of small busnesses. A statstcal model wll be establshed to calculate the credt gap that may exst for those frms that are both credt constraned and ndebted. It s assumed that a frm s credt demand s determned by four elements: 1) the operatons of the frm; 2) the owner of the frm; 3) the relatonshp of the frm to the bank; and 4) the credt constrants and convenence to credt. Snce only those frms that are both credt constraned and ndebted are chosen, the sample selecton bas problems must be dealt wth. Many researchers (Stan, 2000; Berger 2002; DeYoung et al., 2003) prevously have ponted out that large banks tend to gnore the credt demand from small busnesses, but small fnancal nsttutons have the nformatonal advantage and organzatonal flexblty to lend to small busnesses. However, specalzng n small busnesses loans can brng hgh fnancal rsk to small fnancal nsttutons because the repayment rsk (or 4

17 default rsk) for small busnesses s much hgher than for large frms. It s necessary that some rsk management mechansms be establshed for small busnesses lendng. In the fnal secton, the practce of credt scorng n large fnancal nsttutons lke credt card companes s consdered as a soluton to be used as a pre-transacton rsk management strategy to screen out unqualfed potental borrowers. By examnng characterstcs that determne the probablty of repayment through the use of credt scorng, small fnancal nsttutons can quantfy the default rsk for each customer. Clent data from Communty Ventures Corporaton (CVC), a small fnancal nsttuton n Lexngton, Kentucky, wll be used to test the effectveness of such a statstcal credtscorng mechansm. 5

18 Chapter 2 Theoretcal Background 2.1 Market Falure for Small-Busness Lendng I: Informaton Asymmetry across Credt Markets In classcal economcs, the market reaches equlbrum under the unseen hand mechansm,.e., demand wll always be met by supply under some prce level wth no supply surplus or demand gap. In the credt market, such equlbrum can hardly be reached because nformaton between lenders and borrowers s not transparent, but always asymmetrc. Asymmetrc nformaton leads to credt ratonng the credt supply s not large enough to cover the credt demand creatng a credt gap. Secton 2.1 llustrates an deal stuaton (wthout asymmetrc nformaton) between the lender and borrower. An economc background can llustrate why a credt gap may exst n the credt market, ncludng small-busness lendng Supply-and-Demand Prncples for Fnancal Intermedares Small-busness lendng nsttutons, whch nclude banks that ether accept funds or lend funds for consumpton and nvestment, are one of the fnancal ntermedares n the credt market. Prncples of supply-and-demand n the credt market can also be appled to these nsttutons. Fnancal ntermedares can facltate economc development by mprovng effcency wth whch resources are allocated and utlzed across dstance and tme. The economc theory that fnancal ntermedares n general mprove the effcency of the resources used wll be llustrated by the followng graphc analyss. An deal stuaton wll frst be analyzed, n whch transacton costs do not exst. Then economc factors that reflect realty wll be added. Fgure 2.1 reflects the supply-and-demand envronment of fnancal ntermedaton. 6

19 Fgure 2.1 Supply and Demand of Fnancal Intermedares Market Interest Rate S 2 S 1 D a S R 1 d R 2 e R * b R 3 g R 4 f c Q 1 Q 2 Q * Fnancal Insttutons Source: World Bank, 1989 The supply curve (S) represents the economy s supply of funds. As the return (nterest rate) ncreases, the supply (savngs) wll rse accordngly. The demand (D) represents the economy s demand for credt. The downward slopng of D means as the costs of borrowng ncrease, the demand for credt for nvestment or consumpton wll declne. In an deal stuaton, wthout transacton costs, market equlbrum wll be reached where the nterest rate s R * and the volume of fnancal ntermedaton would be Q *. The market for the ntermedaton has reached Pareto effcency, where the demand and supply are the same number. However, n realty, transacton costs do exst because the lender must have nformaton about the borrower, whch brngs costs. The ncurred costs are reflected n the lendng nterest rates. The ncreased nterest rate that lenders must charge borrowers to cover the transacton costs leads the supply curve to shft from S to S 1. The vertcal dstance s the transacton costs. The lender now would be wllng to 7

20 supply Q 1 to earn R 4. For such credt, the borrower would be payng R 1. Transacton costs ntroduce a gap between the cost for borrowers and the return for lenders. The supply amount of the fnancal nsttuton decreases from Q * to Q 1. Such a wedge makes the deadweght loss of socal welfare equal to area, abc. Fnancal nsttutons can reduce the transacton cost by accumulatng nformaton over tme as they become more specalzed and utlze economc scale. Such actons can reduce the lenders cost from ac to eg, whch s reflected by the shft of supply curve from S 2 to S 1. The wedge between the costs to borrowers and the return to lender reduces and the credt supply ncreases to Q 2. Now the deadweght loss to the socal welfare s egb. The lower transacton costs and ncreased number of fnancal nsttutons can decrease the deadweght loss by areas ade and cfg, ndcatng socal welfare s mproved by more fnancal nsttutons. The hgher return for the lenders (from R 4 to R 3 ) and the lower the costs to borrowers (from R 1 to R 2 ) can also ncrease nvestment, consumpton, and savngs. The hgher nterest return wll attract more savngs and the lower cost of borrowng wll produce more ncentves to nvest and consume Characterstcs of the Credt Market Accordng to the neoclassc theory of nvestment, a frm has unlmted fundng opportuntes snce fnancal markets are perfect. That means nternal and external funds are perfect substtutes under the condtons of no transacton cost or nformaton costs (Modglan and Mller, 1958). However, such an assumpton s nvald n the presence of asymmetrc nformaton. The fund lenders always have less nformaton about the proftablty and rsk of the projects than the borrower frms themselves. Asymmetrc nformaton wthn the credt market was frst analyzed n the model of Stgltz and Wess (1981) showng that credt ratonng happens as the result of nformaton asymmetry between lenders and borrowers. The prce of the loan,.e., nterest on the loans, s dfferent from the expected return of the loans because the expected return of the loans also depends on the probablty of the repayment. The nterest rates also affect the repayment of loans because of moral hazard and adverse selecton. When the borrowers are charged too hgh nterest rates, the repayment 8

21 probablty can be decreased for those two effects, whch would reduce the expected return rate. Adverse selecton happens when lenders select the more rsky borrowers and charge hgher nterest rates. Accordng to Stgltz and Wess (1981), there are two effects from rasng nterest. The usual effect s that the expected return wll rse as the nterest charged on the loan rses. Another effect s the opposte effect brought by adverse selecton,.e., the pool of applcants ncreasngly contans borrowers wth hgh-return, hgh-rsk projects. Those borrowers who are wllng to pay hgh nterest rates usually have hgh-return, hgh-rsk projects. The borrower wth low-return, low-rsk projects wll be ruled out of the pool because the hgher nterest rates may be unaffordable for them. The adverse selecton effect on the pool of borrowers produces a lower repayment probablty and the expected return wll declne. Moral hazard s nvolved when an ncrease n nterest rates adversely changes the behavor of borrowers. Stgltz and Wess (1981) show that ncreased nterest rates can make rsker projects more attractve than lower-rsk, lower-return projects. Rasng nterest rates may nduce borrowers to change ther rsk atttude and take on rsker projects, also cuttng down the expected returns to the bank. A lender wll balance the drect effect by rasng the nterest. Interest rates must also be rased to offset the sde effects brought about by adverse selecton and moral hazard. When the nterest rate s low, the drect postve effect may be domnant. That s, the expected return rate has a postve relatonshp wth the nterest rates they charge when the nterest rate s low. The expected return to the lender wll attan a certan level. After that, the expected return wll decrease because the hgher nterest draws the more rsky customers and projects as the moral hazard and adverse selecton effects become domnant. As a result, n response to the excess demand for credt, lenders wll employ credt ratonng rather than rasng nterest rates. The credt ratonng mechansm s llustrated n Fgure

22 Fgure 2.2 Determnaton of a Lender s Equlbrum Interest L L D L * s L L s R * R R m R L s ρ Source: Stgltz and Wess, 1981 The demand of the loans (L D ) s a decreasng functon of nterest rates (R) charged on the loans, whch s reflected by the downward slope. The shape of the supply of funds (L S ) s derved from the relatonshp between the expected return ( ρ ) and the nterest rate of the loan funds. The relatonshp between ρ and R s affected by adverse selecton and moral hazard: ρ ncreases as R ncreases to R * and decrease as R exceeds R *. The supply of loans L S s postvely related to ρ. At R *, the supply of loans reaches ts largest output. Any bank that rases ts nterest rate beyond R * wll lower ts expected return. Therefore, no bank wll rase the nterest rate to elmnate the excess demand, resultng n credt ratonng. At R m, the loans supply equals the loan demand but t s not a fnal equlbrum nterest rate. The banks can get the largest expected return at R * rather than R m. Therefore, the fnal loan supply L * s less the loan demand L D. The exstence of montorng costs can produce equlbrums n whch credt ratonng happens, even wthout adverse selecton and moral hazard problems. Wllamson s model 10

23 (1987) complements Stgltz and Wess s (1981) concluson by focusng on the montorng cost. Debt contracts were derved endogenously as the optmal arrangements between borrowers and lenders. Such contracts can reduce montorng costs. In a gven debt contract, the probablty s that montorng happens and the expected costs of montorng ncreases wth the loans nterest rate. An equlbrum exsts: hgher bdders offer hgher nterests to the lenders and ncur hgher costs; but the fnal expected returns can stll be greater for the lender, wth results that some agents cannot receve loans. Bester (1985) argues that f there s a sgnalng mechansm that the bank requres collateral for ther loans, credt ratonng wll not happen; and, f banks smultaneously (rather than respectvely) choose the collateral requrement and nterest rate as the screenng nstruments, credt ratonng wll not occur. Bester thnks that f the preference of borrowers depends on ther rsk types, the lower-rsk borrowers are more nclned to accept the credt contract that demands hgher collateral and lower nterest rsk. Lowerrsk borrowers also thnk they have a lower probablty to lose the collateral, whch wll make them beneft from the lower nterest rate. The low-rsk entrepreneurs have been assumed to be able to rase a suffcent amount of collateral to dstngush themselves from hgher-rsk ones. (Bester, 1985) If there are enough banks offerng dfferent credt contracts, lower-rsk borrowers who are dened ther preferred loans wll apply for other contracts chosen by less rsky borrowers. Thus, a credt ratonng equlbrum always pools good and bad rsks. Hghrsk borrowers select the credt contract wth a hgher nterest rate and lower collateral requrement whle low-rsk borrowers select the opposte contracts. Besdes asymmetrc nformaton, there are several exogenous factors placng constrants on the supply of fnancal nsttutons, among them, nterest rate floors and celngs. Interest rate celngs repress the loans supplers ncentves and act as the man constrants for the low-ncome borrowers to obtan funds n markets. Hoff and Stgltz (1990) argue that modest fnancal represson can lower borrower costs and boost ther debt-to-equty rato, leadng them to nvest more responsbly, snce they have a larger stake n the project. 11

24 2.1.3 Specal Market Partcpants n Small-Busness Lendng A sgnfcant number of the clents of small-busness lendng are from the workng poor : those who operate mcro or small enterprses and/or work for wages or commssons (Remeny, 1991). Ths term s smlar to the defnton, by Robnson (2002), of the economcally actve poor for customers of mcrofnance nsttutons. Contrary to the extremely poor, the economcally actve poor have some form of employment, are not desttute, and do not suffer a severe food defct. The extreme poor exst below the mnmum subsstence level. They nclude those who are unemployed or severely underemployed, as well as those whose work s so poorly remunerated that ther purchasng power does not permt them to overcome malnutrton. Fgure 2.3 Clents of Small-Busness Lendng (Workng Poor) Workng Poor Entrepreneural Poor (Self-employed and employer) Self-employed Poor (Employ themselves only) Laborng Poor (Workng for others) Extreme Poor (Unemployed) Source: Robnson, 2002 The characterstcs of workng-poor clents worsen the nformaton opacty problems n small-busness lendng. In contrast to large frms, the small frms of the workng poor normally do not enter nto contracts that are generally known or vsble to the publc or are wdely reported n the press. They cannot ssue traded securtes that are publcly prced n markets and even lack audted fnancal statements that could be shown to credt provders. As a result, these small frms have dffculty conveyng ther qualty and overcomng ther nformaton opacty problems. The credt gap between the small frm s 12

25 demand and the credt supply can be expected to be more serous than t s for large frms. In Chapter 3, such credt gaps n small busness frms wll be quantfed usng the 1998 Natonal Survey of Small Busness Fnancal Data. 2.2 Market Falure for Small-Busness Lendng II: Spatal Informaton Asymmetry across Regons As llustrated n Secton 2.1, credt gaps exst n fnancal markets when the nformaton between borrowers and lenders s asymmetrc. Such credt gaps are not homogenous across regons. Often, credt condtons for busnesses n nner ctes and rural areas are much more constraned than for busnesses n more prosperous areas. The captal gap (ncludng the credt gap) s regarded as the prmary barrer to new markets n nner ctes and rural areas. Ths phenomenon can be attrbuted to the nhomogeneous nformaton dstrbuton across regons, resultng from the dfferences n the producton of publc nformaton n these areas The Vcous Cycle of Market Falure Informaton producton has costs lke other market goods producton (Stgler, 1961). Market falure wll not happen f enough nformaton s provded wth margnal costs equalng the market beneft. However, such an deal stuaton does not exst n real economc lfe. Grossman and Stgltz (1980) llustrate that not all possble nformaton wll be produced. In equlbrum, market falure happens when the market does not produce all the possble nformaton, especally n a low-volume market. A smlar but more general vew regardng the economcs of nformaton Greenwald and Stgltz (1986) s that when mperfect nformaton exsts, markets are not constraned by Pareto effcency. Ths pecunary externalty can have real socoeconomc welfare consequences n the economes of mperfect nformaton. The ablty of government to mprove the stuaton by a Pareto-mprovng exchange depends on the volume and qualty of nformaton (Stgltz, 2000). Along wth these vews, government nterventon n markets for welfare enhancement s also justfed, but the successful functonng of such nterventon depends on the avalablty of good nformaton. Weler (2000) also dscusses nformaton dstrbuton asymmetry across regons and ts mpact on economc development. The general assumpton of classcal welfare 13

26 economcs, regardng the effcency of prvate markets that all actors have full nformaton about market opportuntes, cost, and beneft s deemed nvald by Weler (2000). In laggng regons, nformaton that would postvely affect market development s lackng. Ths defcency of regonal nformaton can cause proftable nvestment opportuntes to be gnored and local development wll be negatvely affected. Regonal nformaton also has the characterstcs of publc goods. Every agent n the market has access to t and can consume t to ther maxmum beneft, creatng dsncentves for nformaton producton. Less nformaton producton and accumulaton n the less developed areas lead to less nvestment and busness opportuntes, formng a cycle of margnalzaton n market development. Government nterventon by the publc provson of nformaton could help break the cycle and contrbute greatly to market effcency. These prncples are borrowed to analyze the fnancal market falure n perpheral markets that ncludes the rural credt markets and poor communtes n urban areas, and explan why the credt demand of small busnesses n these areas cannot be satsfed. In the markets of less developed areas that are restrcted by low volume or geographc solaton, the costs of the nformaton wll be much hgher than the benefts. Markets n less developed areas tend not to supply enough nformaton for ther development, formng a cycle destructve to local development. Felsensten and Flescher (2002) also speak of the thn market, where smallbusness borrowers n perpheral areas are more credt constraned because of the nformaton asymmetry exstng between lenders and borrowers n these remote areas. Informaton scarcty brngs hgher transacton costs. The characterstcs of mcroentrepreneurs (no qualfed collateral, less experence, small loan amounts) further exacerbate the hgh cost problems and lead to the reluctance of lenders to provde loans for mcroentrepreneurs. Ther research demonstrates how publc nterventon could promote mcroentrepreneurshp by usng data from a publc program n Israel and emprcally testng whether targeted programs could reduce nformaton asymmetry, thereby makng frms n perpheral areas more attractve to lenders. The regresson results show that a publc-nterventon program could mtgate nformaton asymmetry by helpng small frms n remote locatons generate more vsblty. The problem of market mperfecton may thus be addressed. 14

27 Scorsone and Weler (2004) are the frst to connect busness- and polcy-orented research to the mcroeconomc foundaton of nformatonal asymmetres and market falures. Because of ther solaton from the manstream markets, thn markets face an nformaton hurdle to ncreased economc actvtes. The nformaton gaps n these markets are due to the lack of prvate-sector transactons. Along wth the lmted volume of transactons n the thn market, busness nvestment wll be negatvely affected because of the unavalablty of nformaton about local economc condtons such as labor market condtons, government regulatons, market competton, etc. In addton, nformaton producton has a hgh fxed cost, and only after more data and nformaton flow n, can the accuracy of nformaton be guaranteed and average costs of nformaton be cut down. Less data n the thn market for fewer transactons wll create dsncentves for nformaton producton. The thck market has the nformaton advantage due to more transactons and lower average costs of nformaton. Captal and labor wll flow to those thck markets where nformaton costs are low and the payoff and rsks are subsequently more transparent, resultng n geographc adverse selecton. Even valuable projects n the perpheral markets may be gnored by the captal market. Although opportuntes n thn markets may actually be of consderable qualty, poor comparatve nformaton on related ventures n such areas mples that such projects wll face adverse selecton through no nherent weakness of ther own. It s the thn market tself that hnder such projects, not the projects themselves. The destructve cycle happens when thn markets dscourage good projects, ensurng that these markets wll reman thn. (Scorsone et al., 2004; p. 303) Informaton on the local level also has a publc goods characterstc. Once produced, any agent n the market can take a share n t. Because the hgh costs of producton can make the prvate supply of such nformaton mpossble, there s a role for government provson of nformaton that can address market falure n less developed regons and promote market effcency and regonal equty. The perncous cycle of neglect and margnalzaton wll also happen n the perpheral (rural areas or poor communtes n urban areas) credt markets. The number of transactons n the perpheral markets s very lmted. Such lmted transactons n a stagnatng market mply poor nformaton and hgh varances. (Scorsone and Weler, 15

28 2004) The consequental hgh costs dscourage credt supplers from provdng loans n these markets. In summary, the credt gap n perpheral markets can be attrbuted to a lower level of development, resultng from a lower level of publc nformaton accumulaton. The prncple s as follows: the perpheral markets have less loan transactons and accumulate comparatvely lmted publc nformaton; such lmted nformaton ncreases the nvestment rsk and results n less nvestment n local projects, whch depresses external nvestments; and, the lack of nvestment and other fnancal servces ncreases the margnalzaton of the perpheral market. A cycle destructve to development forms n these perpheral areas. If fnancal nsttutons could overcome the lmted nformaton obstacle, they mght enter these markets and survve Necessty of Government Interventon To realze the dual gan of market effcency and regonal equty, government can ntervene to correct the falure of perpheral credt markets. However, drect government partcpaton n these markets wll produce publc goods nformaton, and can depress ncentves to produce more nformaton. Actually, government already partcpates ndrectly n the markets. A model llustratng the relatonshp among small busness frms, government, and small fnancal nsttutons s presented n Appendx 2. The government provdes loans to small fnancal nsttutons and demands certan requrements from them ncludng socal effect and self-sustanablty. These two goals compel small fnancal nsttutons to seek and lend to qualfed local entrepreneurs, whch lead to more transactons and contrbute to local development. Local mcroentrepreneurs are famlar wth the local demand and have a hgher probablty to succeed n ntatng local busnesses. Durng the process, small fnancal nsttutons work as ntermedares that speed-up nformaton dssemnaton. More transactons wll be produced. The demand gap of small busnesses often gnored by the formal fnancal supplers wll be covered. A benevolent nformaton cycle wll also be created. The new credt market nformaton ntatve wll promote both economc effcency and equty by focusng on neglected busness opportuntes created by the small busness owners. 16

29 2.3 Market Falure for Small-Busness Lendng III: A More Consoldated Market Structure Consoldaton Trends n the Credt Market Both the bankng consoldaton of the last two decades and the tremendous change n the commercal bankng ndustry durng ths perod contrbute to the exstence of the credt gap for small busness. Two mportant laws, the Depostory Insttutons Deregulaton and Monetary Control Act of 1980 and the Garn-St German Depostory Insttutons Act of 1982, removed many regulatons that had lmted competton between banks and nonbanks. As a result of these deregulatory acts, the bankng ndustry experenced an ntense perod of consoldaton. Nearly 3,000 banks merged from 1987 to 1994 (Ely et al., 2001). Another drvng force behnd the ncreased consoldaton s the deregulaton of restrctons on geographcal expanson by the Regle-Neal Interstate Bankng and Branchng Effcency Act of As a result of these polces, consoldaton produced larger bankng companes wth more complex organzatonal structures. The costs of lendng to small busness are hgher for larger banks than for the reduced number of small banks because large bank s herarchy systems nablty to deal wth the relatonshp lendng n small busness loans (Berger and Udell, 1995; Strahan and Weston, 1998). As a result, access to credt by small busnesses has dmnshed. The consoldaton of banks rased polcy concerns due to emprcal research that shows large bankng nsttutons devote proportonally less assets to small-busness loans than small nsttutons (Berger and Udell, 1995; Strahan and Weston, 1998; Peek and Rosengren, 1998). Drect proof of ths can be derved from the June, 1999 Call Reports data, showng banks wth less than US$100 mllon n assets had about 9 percent of ther portfolos nvested n small-busness loans, whle banks wth over US$10 bllon n assets devoted only about 2 percent of ther assets to these loans The Organzatonal Dseconomy of Consoldated Banks The reasons for the dsnclnaton of large banks to lend to small busnesses have been put forth by much prevous research. Small busness loans are often nvolved wth relatonshp lendng. Large nsttutons can hardly provde relatonshp-drven loans 17

30 because the organzatonal structure of large banks makes t too costly to provde a relatonshp-based servce that often demands ntmate knowledge ganed through contact over tme wth small busness owners and ther market (Wllamson, 1987). The reducton of asymmetrc nformaton s at the heart of the fnancal ntermedaton process. Economc theores of nformaton can llustrate why the consoldated large fnancal nsttutons are dsnclned to lend to small busness, and why small fnancal nsttutons have an organzatonal and nformatonal advantage over large fnancal nsttutons. The argument that small fnancal nsttutons can specally serve small busnesses s based on a seres of prevous research results. The phenomenon that the large formal fnancal nsttutons often gnore the credt demand from small busnesses s concsely summarzed by Berger and Udell (1998): The larger nsttutons created by consoldaton may also choose to provde fewer retal servces to small customers because of Wllamson-type (1987) organzatonal dseconomy Ths dseconomy may be most lkely to arse n provdng servces to nformatonally opaque small busnesses for whom ntmate knowledge of the small busnesses, ts owner and ts local market ganed over tme through a relatonshp wth the fnancal nsttutons s mportant. (Pp.165 6) Several emprcal studes complement the fndngs of Berger and Udell (1998). Nakamura (1994), Strahan and Weston (1998) llustrate that small banks nvest a sgnfcantly larger share of ther assets n small-busness loans than do larger formal banks. Such a tendency becomes more obvous when after large banks acqure small banks (Peek and Rosengren, 1998). Many of the small-busness loans cut n the process of consoldaton are pcked up by small banks n the local market. Although the research suggests that t may be dsadvantageous for large fnancal nsttutons to lend to small busnesses, t does not explan the reasons for ths phenomenon. Other research stresses that the complex organzatonal structure rather than the sze of the bank makes t dsadvantageous for a large bank to lend to small busnesses (De Young, et al., 1997). Holdng constant a bank s sze and age, the number of a bank s branches has a sgnfcant relatonshp to the probablty that a bank lends to small busness. These studes focus on the form rather than sze of the organzaton to explan a 18

31 bank s lendng proclvty, but do not explan why the organzatonal form could affect a bank s lendng nclnaton. Other evdence shows some large formal fnancal nsttutons make loans to small busnesses, but tend to avod the small busnesses that are not forthcomng wth soft nformaton that the fnancal nsttutons use to assess project worthness. Berger and Udell (1995) fnd that large banks only lend to the small busness wth a strong fnancal poston and that soft nformaton may not be necessary. Through a 1993 survey of small busness fnance, Cole, et al. (1999) fnd that the loan approval patterns of dfferent banks depend on what nformaton they rely on. Large banks depend more on the ratos n the standard fnancal statement, whle small banks devate from those crtera and seem to rely to a larger extent on ther mpresson of the character of the borrower. Soft nformaton s the nstrument that the small banks prefer to use to make loan decsons. The results of the study by Cole, et al. (1999) could explan the dsparty of lendng patterns among fnancal nsttutons,.e., banks of dfferent scale have dfferent capactes to handle soft nformaton, whch determnes ther nche preferences n the credt market The GHM (Grossman, Hart, and Moore) Paradgm and More Wthn the theores of organzatonal economcs, answers can be found to the queston of why large and small fnancal nsttutons are better at carryng out specfc tasks n ther respectve nches. The lterature analyzes n more detal reasons why small fnancal nsttutons can have a comparatve advantage n ther nche market. Coarse (1937) rases the queston of what determnes the operatonal boundares of frms by askng when vertcal ntegraton (upstream and downstream) actvtes could make sense for a frm s operaton, as llustrated n the commercal bankng ndustry, as to whether the consoldated large banks wll behave dfferently than the small fnancal nsttutons that they are dsplacng. On the bass of transacton-cost economcs, Wllamson (1985) partly answered the queston by showng that the advantage of ntegraton n a large-scale operaton s that hold-up problems n the compettve market can be mtgated, whle the dsadvantage of ntegraton s not shown. Standng on the pont of property rghts, Grossman and Stgltz (1986), Hart (1995), and Moore 19

32 (1990) (GHM) demonstrate the dsadvantage of ntegraton. At a very general level, the crtcal pont of the GHM paradgm s that n a world of ncomplete contracts, agents ex ante ncentves are shaped by the extent to whch they have control or authorty over some physcal assets. After ntegraton, the prevous presdent now may become subordnate to the presdent of the newly merged frm and become dscouraged. Therefore, the manager s ex ante nvestment may be reduced. The potental cost of ntegraton and the large-scale operatons s shown. GHM paradgms have a great nfluence on the development theores of frms. Many emprcal studes have focused on testng for a specfc type of nvestment or n a partcular nsttutonal settng. The most drect theoretcal background s establshed by Sten (2000). The subject of Sten s research s not just constraned n the bankng ndustry but apples generally to all ndustres. It answers the queston of how the nature of an organzaton affects both the way t does busness and the knds of actvtes that t can effcently undertake. Sten s model shows how a small organzaton can perform some tasks better than a large organzaton. Sten s model also adopts nsghts from the GHM paradgm, such as, the allocaton of control affects ncentves, but hs model provdes a more mcrolevel analyss on the bass of nformaton. It ponts out that dfferent ncentves are created n large and small frms for the producton and use of varous knds of nformaton. When nformaton about a project s soft and cannot be communcated easly from one agent n the frm to another, small frms are at a comparatve advantage n handlng that knd of nformaton and evaluatng such nvestment projects. In contrast, large frms can easly handle hard nformaton, whch can be passed smoothly through ther herarchcal systems. An example of soft nformaton s a loan offcer who has worked wth a loan applcant and may know whether the borrower s honest and hard workng or not, but cannot document ths nformaton n a report that can be passed on to the supervsor. Ths contrasts wth the loan applcaton approval process for a credt card or home mortgage, where decsonmakng mostly depends on hard or verfable nformaton such as tax returns or an annual balance sheet. 20

33 A more specfc descrpton of how organzatonal forms can affect operatonal goals and effcency n specfc markets s presented n the followng example taken from Sten (2000). For a loan offcer who s also the presdent of a small bank, hs judgment when determnng whch small loans are worth lendng depends on how well he can produce the soft nformaton and ths, n turn, also affects hs ncentve. As the loan offcer wth the authorty to allocate funds, he knows that hs research wll not be wasted and hence hs ncentves to research the nformaton are strong. In a formal way, the decentralzaton nherent n a small bank rewards an agent who develops expertse by ensurng that he wll have some captal whch he can use to lever the expertse. In contrast, ncentves problems arse f the loan offcer producng soft nformaton s part of a large mult-branched herarchcal nsttuton and a supervsor at a hgher level than the loan offcer has the fnal decson about the lendng opportuntes of the organzaton. In ths case the authorty to allocate fundng s obvously separated from expertse f the loan offcer has no chance to act on the soft nformaton he produces. Hs advce s not accepted, hs research efforts go to waste, and hs ncentves for future research are repressed. However, f the nformaton produced by the loan offcer n a large nsttuton can be hardened or easly transferred to supervsors, ncentve problems wll dsappear as large fnancal nsttutons drect the efforts of ther agents to more research. If the nformaton can be hardened through statstcal analyss or credt scorng, the loan offcer can more easly provde verfable nformaton to hs supervsor, demonstratng strong decsonmakng, whch n turn, leads to an ncrease of control over the budget share. In a large nsttuton, separatng authorty from expertse actually mproves the research ncentves of lower level loan offcers who, by producng verfable hard nformaton, convnce ther supervsors they deserve more lendng authorty The Role of Small Fnancal Insttutons The studes above, especally Sten s (2000) model, show that nformaton and organzaton structure are key factors determnng lendng actvty. The herarchcal structure of large fnancal nsttutons makes the transfer of soft nformaton dffcult, a 21