Relationship Banking and SMEs A Theoretical Analysis

Transcription

1 Dscusson Paper Seres A No.470 Relatonshp Bankng and SMEs A Theoretcal Analyss Tmo Baas (DIW Berln [German Insttute for Economc Research]) and Mechthld Schrooten (Assocate Professor, The Insttute of Economc Research, Htotsubash Unversty DIW Berln [German Insttute for Economc Research]) December, 2005 The Insttute of Economc Research Htotsubash Unversty Kuntach, Tokyo, Japan

2 Relatonshp Bankng and SMEs A Theoretcal Analyss* Ths verson: December 2005 by Tmo Baas and Mechthld Schrooten ** * We are grateful to Franzska Holz, Carolne Kp, Clauda Nassf, Dorothea Schaefer, Phlpp Schroeder, the DIW fnancal market group and an anonymous referee for valuable comments on an earler verson of the paper. ** Tmo Baas, DIW Berln (German Insttute for Economc Research) Koengn-Luse-Str. 5, Berln, Germany, emal: tbaas@dw.de and Unversty Potsdam, Faculty of Economcs, August-Bebel-Str. 89, Potsdam baas@rz.un-potsdam.de. Mechthld Schrooten DIW Berln (German Insttute for Economc Research) Koengn-Luse-Str. 5, Berln, Germany, emal: mschrooten@dw.de and Htotsubash Unversty, 2-1 Naka Kuntach, Tokyo, Japan emal: mechtld@er.ht-u.ac.p. Correspondng author: Mechthld Schrooten, German Insttute for Economc Research (DIW Berln), Koengn-Luse-Str. 5, D Berln, Germany. emal: mschrooten@dw.de; mechtld@er.ht-u.ac.p Suggested abbrevaton of the ttle: Relatonshp bankng 1

3 Relatonshp Bankng and SMEs A Theoretcal Analyss Abstract: Relable nformaton on small and medum szed enterprses (SMEs) s rare and costly for fnancal ntermedares. Therefore relatonshp bankng s often consdered as the approprate lendng technque. In ths paper we offer a theoretcal model to analyze relatonshp bankng and the prcng behavor of banks n a Bertrand competton framework wth montorng costs. We show that the lack of relable nformaton leads to comparably hgh nterest rates even f a long-term relatonshp between borrower and bank exsts. The paper offers a theoretcal explanaton why SMEs often are faced wth borrowng constrants. (91 words) Keywords: JEL-classfcaton: Relatonshp Bankng, Fnancal Constrants, Small and Medum Szed Enterprses, Accountng D43, D 82, G21, M41 2

4 1. Introducton Typcally n ndustralzed countres, small- and medum-szed enterprses (SMEs) account for more than 90 percent of all frms, they employ about two-thrds of the workforce, and contrbute to nearly 50 percent of the value added n non-agrcultural producton. They are often consdered to play an mportant role n growth promoton and poverty reducton (Bank 1994, 2002, 2004; Beck et. al 2003; Wagenvoort 2003). Nevertheless, t seems to be a global phenomenon that SMEs are confronted wth relatvely harsh credt constrants (Beck and Maksmovc 2002; European Commsson 2002; Beck et. al. 2004). Untl now the analytcal framework concernng prce-settng behavor of banks and nformaton avalablty on SMEs the has been underdeveloped. Snce relable nformaton on SMEs s rare and costly, relatonshp lendng s often consdered as the most approprate lendng technque for collectng nformaton on SMEs (Boot and Mlbourn 2002): the frm and the bank enter n a long-term relatonshp that assures the frm s access to credt and gves the bank access to nformaton about the frm (Allen and Saunders 1991; Nakamura 1992; Berger et. al. 1999; Boot 2000). One mportant characterstc of such a relaton s the ncrease of the value of the nformaton (Schaefer 2003). Therefore, one could expect that loan nterest rates should declne over tme. However, recent emprcal and theoretcal lterature on relatonshp bankng offers ambguous results: Peterson and Raan (1994) suggest that loan nterest rates declne wth relatonshp lendng. 1 The opposte effect s descrbed by Greenbaum et. al. (1989) and Sharpe (1990); they demonstrate condtons under whch lenders subsdze borrowers n early perods and are rembursed n later perods. 2 Based on so-called soft nformaton, ths lendng technque s manly generated by the bank s past experence wth a gven lender. Here, we take a closer look at ths problem and develop a theoretcal model to analyse the effects of the lendng technque on the nterest rate. Prevous studes, where perfect competton s mpeded by asymmetrc nformaton, show that professonal fnancal ntermedares lke banks can beneft from economes of scale n obtanng nformaton about borrowers (Stgltz and Wess 1981; Damond 1984, 1991; Ramakrshnan and Thakor 1984; Boyd and Prescott 1986). 3 The man dfference between our artcle and these prevous studes s that we focus on proft maxmzaton of banks and take nto account the specfc lendng technque used by banks. 3

5 We show that the choce of the lendng technque s crucal for the cost functon of the bank. These costs occur from the costs of montorng borrowers, the costs of refnancng credts and the costs of lendng to borrowers who cannot pay back ther credt (bad loans). The lendng technque affects two components of the costs of a bank. Frst, the lendng technque determnes the montorng cost curve. Second, t affects the effcency of montorng and therefore the share of bad loans n the portfolo of banks. We argue on the bass of a Bertrand competton framework - frequently used n the credt market lterature (Dell Arcca et. al. 1999; Jun and Vves 2004). An mportant advantage of ths type of competton s that polypoly effects are generated n the duopoly case. Therefore dfferences n lendng technques are not superposed by duopoly effects,.e. by strategc nteractons between banks or frms. The lack of borrower market power s a key assumpton of Bertrand competton (Gal-or 1986; Bracoud 2002). We show that there exst lnkages between the chosen lendng technque and the loan nterest rate. The maor fndng of our paper s that wth a longer duraton of the lendng relatonshp, loan nterest rates are not reduced. Furthermore, we show that n markets where banks rely on relatonshp lendng, borrowers are charged hgher nterest rates compared to markets where relatonshp lendng and credt scorng/fnancal statement lendng coexst. The remander of the paper s organzed as follows: n secton 2 we develop a model of bankng wth dfferent lendng technques. In secton 3 we dscuss the results of the model, whle secton 4 offers conclusons. 2. The Model Fnancal ntermedares need nformaton on potental borrowers. Only on the base of suffcent nformaton they can make an effcent decson whether to fnance a gven nvestment proect or not. Nevertheless, relable nformaton on frms s not always publcly avalable. Especally SMEs usually are not forced to use sophstcated accountng technques and to publsh ther balance sheets. Therefore nformaton on these enterprses s relatvely costly. In such a case a fnancal ntermedary mght try to use relatonshp bankng to collect nformaton on the potental borrower over tme. In general, a bank has the possblty to montor borrowers and to gan nformaton on potental nvestment proects. Montorng causes costs ( t ) 4. The ncentve for banks to

6 montor arses from the assumpton of prohbtve costs n the case of non-montorng. If a bank chooses the relatonshp lendng technque montorng costs are a functon of the maturty of the bank-borrower relaton. In the case of fnancal statement lendng they are constant and do not vary wth the duraton of the bank-borrower relatonshp (table 1). Consequently, f banks dffer wth respect to the lendng technque, they wll have dfferent (montorng) cost curves (box 1). But does relatonshp lendng lead to lower nterest rates for borrowers wth long-term relatonshps? <nsert table 1> <nsert box 1> 2.1 The general structure of the model We assume a number ( A ) of borrowers. Each of them wants to realze a sngle nvestment proect that requres one unt of fundng and generates a random return. These borrowers are atomc and therefore have no market power. Market demand for fnance s generated by a contnuum of nvestors represented by the atomc probablty space ( AAv,, ). Let the demand functon d : ++ A be such that the ntegral D ( p) = d(, r a) dv() a s well defned for A every r ++. For any borrower a A, dra (, ) specfes hs demand f he can borrow at any gven (postve) nterest rate r. The total market demand functon D () ndcates the aggregate amount of credt that all nvestors together are wllng to take at a gven (postve) nterest rate (e.g. Allen and Hellwg 1993). The frms can have ether good or bad nvestment opportuntes, so that there s a share of ( q ) good and ( 1 q) bad nvestment proects. The return of the proects g( z ) s characterzed by a bnary random varate ( z ) whch can adopt the values 0 or 1; z { 0,1}. If z s 1, then the proect s successful and the return s non-zero; f z s 0, then the return of the proect s zero as well. G It s assumed that average return g(1) nterest rate: g(1) r s λ of good proects ( ) G λ. Conversely, for bad proects ( 1 q) q s hgher than the save" loan the average return falls below B the safe loan nterest rate: λ g(1) < r s. Because even the frms wth bad opportuntes can be 5

7 successful wth ther proects and even the frms wth good opportuntes can fal, parameter G B λ 1 defnes the probablty of success for good and the parameter λ < 1 for bad proects. We further assume that there exst two banks, and ; at least one of them reles on relatonshp lendng. Banks are the unque provders of funds and have access to compettve captal markets where they can fund themselves at the exogenous nterest rate p. For smplfcaton we assume that the dstrbuton of borrowers regardng the maturty of ther bank relatonshp s a contnuous lne wth one borrower at every pont, lke pearls at a pearl necklace. A bank does not know the behavor of the other bank and thus tests f t can underbd ts compettor by settng lower loan nterest rates. It s further assumed that a bank knows the share of good proects n ts portfolo. Hence the expected (ϕ ˆ) and real shares of good proects (ϕ ) are assumed to be equal ( ˆ ϕ = ϕ). Ths leads to the typcal Bertrand demand functon, where a bank can obtan the entre market, f t can underbd ts compettors. r mn [ q, D( r) ], r > r q R ( r, r ) = r mn q, D( r), r = r q + q 1 q r max 0, mn q, D( r ) r < r Dr ( ) r, wth R, as payoff functon, D( r ) as demand for credts, for banks =1, 2 and. Consequently, the banks n the market maxmze profts and play a non-cooperatve Bertrand- Nash competton game. In ths settng, the payoff functon shows what each player wll receve as the outcome of the game n terms of market share. In the followng sub-sectons we turn to the bank sde of the game. There we show the possble nterest rates whch a bank can charge accordng to ts specfc cost functon. 2.2 The benchmark model: a relatonshp lendng duopoly Consder a market wth two banks that rely on the relatonshp lendng technque. Ths means that every bank has soft nformaton about the busness of a frm (e.g. relablty of the borrower, hstory of the frm, frm s perspectve and new markets). Montorng frms s costly, 6

8 therefore both banks only montor ther own share of the market ( ( x ) or ( x) 1 ). 4 Each borrower s causng dfferent montorng costs dependng on the maturty of the lendng relatonshp. In general, there are two explanatons for the assumpton of a declne n montorng costs over tme: frst, because of better knowledge of e.g. the qualty of ntangble goods, the frm s local market, and export opportuntes, the qualty of nformaton rses and the costs of addtonal data collecton dmnsh. Second, asset-based lendng s used as a substtute when the relatonshp s n an nfant state (Boot 2000); snce ths lendng technque s cost-ntensve, swtchng to relatonshp lendng reduces these costs. The banks and dentfy potentally good nvestment proects wth a montorng effcency of φ, and lend to frms wth these nvestment opportuntes. Snce both banks are relatonshp banks, montorng effcency s the same, φ = φ. Due to the assumed perfect foresght, the margnal costs mc, are: (1.1) mc, = ( f ˆ, + t(1 x))/ ϕ, where ˆϕ, s the expected share of successful proects based on nformaton from prevous perods, f, s the cost functon of a specfc bank and t(1-x) reflects the actual montorng costs. For each credt, both banks face fundng costs p,. The cost functon of the banks s: (1.2) f, = [ qφ, + (1 q)(1 φ, )] p 5,, wth q reflectng the share of good and 1-q the share of bad proects. The share of successful proects ϕ, becomes obvous (1.3) G B, = qφλ, + ( 1 q)(1 φ, λ. ϕ ) Ths leads to the proft functon of the bank : 7

9 (1.4) 1 Ar, D( x) ϕ, f, At(1 x) dx x= π( r, r) = Ar, D( x) ϕ, f, At(1 x) dx wth x= 0 0 r r r > r = r > r Knowng the proft functon of the banks, we can thnk about the possblty of any postve nterest rate a relatonshp bank can charge n ths Bertrand-Nash game. On the lower range of MC possble nterest rates (nterest rates below margnal costs (MC) µ, ( 0, r, ) 8 6 ) nether bank assgns postve probablty. Ths s obvous snce the correspondng proft π, would be negatve for both banks. The medum range of possble nterest rates s defned by MC LBMC ( r +, r ) µ,, ε, wth the parameter ε > 0 ; f ε equals one ths means margnal cost prcng. The range of ths nterval s defned from margnal cost prcng to least borrower margnal cost prcng (LBMC). For ths entre nterval the probablty of realzaton s 0 snce there exsts at least one slghtly hgher nterest rate whch results n larger profts. Ths s caused by montorng costs rsng margnal costs above the average level. Therefore f a bank can underbd ts compettor by a margnal reducton of r, ths bank would gan the whole market, but because of rsng montorng costs would lose proft even f t does not serve the whole market. There s only one nterval of possble nterest rates left: LBMC ( r + ) µ ε,,,. In Nash equlbrum, f a bank charges nterest rates above margnal costs ε > 0, expected profts wll be zero snce ths bank expects the other bank to underbd ts nterest rate. Therefore the probablty of a bank choosng a hgher nterest rate than least borrower margnal cost s zero. Result 1: Bertrand competton does not lead to margnal cost prcng. 7 Ths s caused by montorng cost advantages of relatonshp banks that prevent (perfect) competton except market border competton. Consequently, the banks have no ncentve to prcedscrmnate,.e to charge loan nterest rates equal to margnal costs. The banks use

10 unform prcng and charge all borrowers margnal costs of short relatonshp borrowers. In the usual reasonng, the unque pure strategy Bertrand-Nash equlbrum equals margnal costs p = p = mc. As Harrngton (1989) ponted out ths s the only equlbrum outcome * *, when frms produce at constant margnal costs and market demand s bounded, contnuous, downward slopng and has a fnte choke-prce. In ths model we assume nformaton asymmetres caused by the dfferent length of lendng relatonshps. As our result shows there s only one possble equlbrum: an nterest rate (prce) equal to the least borrower margnal cost. Fgure 1 provdes an llustraton. Due to the assumed symmetry of banks ths s exactly a market share of one half for each bank: (1.5) 1 2 ϕ f + ϕt ϕ f = t( ϕ + ϕ ) Ths equlbrum, market share enables the banks to make postve profts. Profts are F1 for bank and F2 for bank. Chargng the least borrowers margnal cost s reflected n pont a n fgure 1. <nsert fgure 1> 2.3 Dfferences n Lendng Technques - the Access of SMEs to External Funds We now turn to cases where SMEs are forced to make fnancal reports that can be used n fnancal statement lendng or credt scorng. We assume that bank reles on relatonshp lendng and bank on fnancal statement lendng. As mentoned n secton 2.1, montorng costs for the bank wth relatonshp lendng dffer between the borrowers. In contrast, the t bank wth fnancal statement lendng faces the same montorng costs for each borrower,. We further assume that the average montorng costs of both banks are equal: 1 2 x= ( t x) t 0 = (1 x) ϕ ϕ wth ϕ = ϕ. 8 9

11 For banks engagng n fnancal statement lendng, Bertrand competton mples loan nterest rates equal to margnal costs: (2.1) r = f + t ϕ The margnal cost prcng of fnancal-statement-lendng banks results n zero profts: (2.2) π A( ϕ r f t ) = 0 = Snce the fnancal statement bank s nformaton s publcly avalable, market entry of another fnancal statement banks s lkely f the fnancal statement bank charges loan nterest rates hgher than margnal costs. The average loan nterest rate charged by banks engaged n a market where fnancal statement lendng s possble s lower than the average nterest rate n a pure relatonshp lendng market. (2.3) r 0,5 f /0,5 1 + txdx A f f t + t + x= 0 = r 2 = = < ϕ ϕ ϕ As a consequence, equlbrum loan nterest rate s lower than the margnal costs of relatonshp lendng banks (least borrower margnal cost). Therefore ths bank serves only the part of the market whch s below the pont where the sum of montorng costs and fundng costs equals the equlbrum loan nterest rate: (2.4) r f + tx * = r = wth x * < 0,5 ϕ 9. 1 Ar, D( x) ϕ, f, At(1 x) dx x= π( r, r) = Ar, D( x) ϕ, f, At(1 x) dx wth x= 0 0 r r > r = r r > r 10

12 MC On the lower range of possble nterest rates, ust lke n 2.2 µ, ( 0, r, ) 11, agan none of the banks assgns a postve probablty. Ths s obvous snce even n ths case the correspondng π, would be negatve for both frms. However, n ths case margnal costs dffer. There are three possble cases: Result 2a) Result 2b) Result 2c) In the frst case, margnal costs caused by the borrower wth the longest relatonshp are above the margnal costs of the fnancal statement lendng bank. Therefore, antcpatng the possblty to underbd the compettor, the fnancal statement lendng bank would charge margnal costs and gan the whole market. Ths bank could ncrease ts profts wth hgher prces, so t rases nterest rates untl a level slghtly below margnal costs of the relatonshp lendng bank s long duraton borrowers. The second possble case s that the margnal costs caused by the relatonshp lendng bank s borrower wth the longest relatonshp equals margnal costs of the fnancal statement lendng bank. In ths case the Bertrand-Nash game leads to zero profts for both banks. In the thrd case margnal costs of the relatonshp lendng bank are below the margnal costs of the fnancal statement lendng bank. In ths case the medum range MC LBMC of possble nterest rates s defned by µ, ( r, + ε, r, ), wth ε > 0, whch means margnal cost prcng. For ths result the probablty s 0 for the relatonshp lendng bank snce there exsts a slghtly hgher nterest rate whch results n larger profts. Ths s due to the montorng costs whch cause margnal costs to rse above the average level. Therefore, f the relatonshp bank can underbd ts compettor by a margnal reducton of r, ths bank would gan the whole market, but due to rsng montorng costs the bank would lose proft even f t does not serve the whole market. Agan there s only one nterval of possble nterest rates left, µ, ( LBMC r, + ε, ). If a bank would charge nterest rates above margnal costs of fnancal statement lendng bank, ε > 0, expected profts would be zero snce ths bank expects the other bank to

13 underbd ts nterest rate. Therefore the probablty of one bank choosng a hgher nterest rate than the fnancal statement bank s margnal cost s be 0. Fgures 2 and 3 llustrate the case 2c for two scenaros of hgh and low fnancal statement margnal costs. If one argues that the market for loans to SMEs s characterzed by a low level of avalable nformaton, ths would result n a market for relatonshp lendng as t s shown n fgure 1 or t would lead to relatvely hgh margnal costs of the fnancal statement lendng, as t s shown n fgure 2. Wth rsng nformaton, lke t s the case for large companes, margnal costs of fnancal statement lendng are reduced. Ths s shown n fgure 3, where the relatonshp lendng bank has only a small share of the market compared to the fnancal statement lendng bank. Furthermore, fgure 2 reflects two possble extensons. If we assume a need to get at least half of the market, the relatonshp lendng bank would subsdze the area F1b wth the area F1a. Ths would be the case f the bank has to gan young borrowers whch have, by assumpton, hgh montorng costs. The second addtonal assumpton s the possblty of swtchng the lendng technque from relatonshp lendng to fnancal statement lendng. The prevalng lendng technque would n ths case be relatonshp lendng untl a crtcal market share, and after ths pont fnancal statement lendng (dotted lne n fgure 2). In fgure 3 both assumptons are ncluded, but wth low margnal costs of fnancal statement lendng; the area F1b extends the are F1a. Therefore subsdzng young borrowers s no longer possble wthout profts to be less than zero. <nsert fgure 2 and fgure 3> 3. Interpretaton of the Results In our model we analyze the mpact of the lendng technque on SME fnance and we explan the behavor of a relatonshp bank n dfferent market envronments. We show that n three varatons of the model, relatonshp lendng has advantages for a bank but not necessarly 12

14 for the borrower. Addtonally, we show that f there s a bank whch s engaged n fnancal statement lendng, ths bank s restrctng the advantages of the relatonshp lendng bank. The central results of the model are: Relatonshp-lendng banks explot nformaton advantages that result from ther lendng technque. If one bank reles on fnancal statement lendng, ths bank drves down the profts of the relatonshp lendng bank by reducng the market prce. In the case of low montorng costs for fnancal statement lendng, the relatonshp lendng bank serves only a small fracton of the market. Loan nterest rates are drectly proportonal to fnancal statement montorng costs. Average montorng costs are lower n the case of relatonshp lendng. Nevertheless, the cost advantages of relatonshp lendng do not necessarly lead to a lower nterest burden for SMEs. The model yelds nterestng results. Frst, relatonshp lendng leads to relatvely hgh loan nterest rates compared to other lendng technques. Second, when assumng a lower effcency of credt scorng, ths type of market structure leads to lower nterest rates than relatonshp lendng. Thrd, the lowest nterest rates are realzed n a market wth one of the banks beng a fnancal statement bank. The model results stress the mportance of the avalablty of dfferent lendng technques to reduce borrowers loan nterest rates. In practce, especally the market of SMEs lacks hgh qualty accountng data, whch makes these frms more dependent on relatonshp bankng than large companes. Snce relatonshp lendng leads to hgh loan nterest rates, SMEs suffer from hgh costs of external fundng. For large companes, a much hgher degree of nformaton s publc and therefore avalable wthout any costs to fnancal ntermedares. Ths enables the banks to apply transacton based lendng (fnancal-statement-lendng or credt-scorng) whch reduces loan nterest rates. 13

15 4. Conclusons and Outlook SMEs seem to suffer from lmted access to external fnancal resources all over the world. Banks usually are reluctant to provde credt to ths type of enterprses. Ths behavor s due to the relatvely lmted publcly avalable nformaton about SMEs. Legal accountng requrements for these enterprses are low, so that managers of SMEs have only small ncentves to nvest n detaled nformaton practces. It s often argued that ths specfc lack of nformaton can be compensated by relatonshp bankng, whch enables banks to collect detaled nformaton about an ndvdual frm over tme. Nevertheless ths nformaton s exclusve. That s why there exsts a close lnkage between the lendng technque of a bank and the nterest rate offered to a frm. Whle relatonshp lendng leads to relatvely hgh nterest rates the burden s much lower n the case of fnancal statement lendng. These results have far-reachng mplcatons for the recent dscusson on the ntroducton of nternatonal accountng standards n Europe. There are strong arguments for an mprovement of the current desgn of accountng standards specfcally for SMEs. Frst, n order to be effcent, nternatonal accountng standards should apply to all types of enterprses. Second, addtonal nformaton ganed through ths process would lead to an mprovement n decsonmakng. Both banks and enterprses would be the benefcares of such a change n the nsttutonal framework. Thrd, the ntroducton of nternatonal accountng standards would have a self-contanng, postve mpact on competton wthn the bankng sector. Gven the large nterest on the nterdependence of bankng and SME fnance further research s necessary. Snce our model s lmted to the supply sde, addng borrower demand would be a natural extenson of the model. In such an extended framework nterest rate effects are expected to be supplemented by reduced demand for credt. 14

16 References Allen, Beth and Martn Hellwg "Bertrand-Edgeworth Duopoly wth Proportonal Resdual Demand." Internatonal Economc Revew, 34:1, pp Allen, Lnda, Anthony Saunders and Gregory.F. Udell "The prcng of retal deposts: Concentraton and nformaton." Journal of Fnancal Intermedaton, 1, pp Beck, Thorsten, Asl Demrgüç-Kunt and Ross Levne "Small and Medum Enterprses, Growth, and Poverty: Cross-Country Evdence." World Bank Polcy Research. Beck, Thorsten and Voslav Maksmovc "Fnancal and Legal Constrants to Frm Growth: Does Sze Matter?" The World Bank, Polcy Research Workng Paper Seres. Berger, Allen N., Seth D. Bonme, Danel M. Covtz and Dana Hancock "Why are bank profts so persstent: the roles of product market competton, nformatonal opacty, and regonal/macroeconomc shocks." Board of Governors of the Federal Reserve System (U.S.), Fnance and Economcs Dscusson Seres. Berger, Allen N. and Gregory F. Udell "Relatonshp Lendng and Lnes of Credt n Small Frm Fnance." Journal of Busness, 68:3, pp Berger, Allen N. and Gregory F. Udell "The economcs of small busness fnance: the roles of prvate equty and debt markets n the fnancal growth cycle." Board of Governors of the Federal Reserve System (U.S.), Fnance and Economcs Dscusson Seres. Berger, Allen N. and Gregory F. Udell "Small Busness Credt Avalablty and Relatonshp Lendng: The Importance of Bank Organsatonal Structure." Economc Journal, 112:477, pp Boot, Arnoud W. A "Relatonshp Bankng: What Do We Know?" Journal of Fnancal Intermedaton, 9:1, pp Boot, Arnoud W. A. and Todd Mlbourn "Credt Ratngs as Coordnaton Mechansm." C.E.P.R. Dscusson Papers. Boot, Arnoud W. A. and Anan V. Thakor "Moral Hazard and Secured Lendng n an Infntely Repeated Credt Market Game." Internatonal Economc Revew, 35:4, pp

17 Boyd, John H. and Edward C. Prescott "Fnancal Intermedary-Coaltons." Journal of Economc Theory, 38:2, pp Bracoud, Frédérque "Sequental Models of Bertrand Competton for Deposts and Loans under Asymmetrc Informaton." Keele Economcs Research Papers, 2002/15. Dell'Arcca, Govann, Ezra Fredman and Robert Marquez "Adverse Selecton as a Barrer to Entry n the Bankng Industry." RAND Journal of Economcs, 30:3. Damond, Douglas W "Fnancal Intermedaton and Delegated Montorng." Revew of Economc Studes, 51:3, pp Damond, Douglas W. and Robert Verreccha "Dsclosure, Lqudty and the Cost of Captal." Journal of Fnance, 46, pp European Commsson "Hghlghts from the 2002 Survey." Observatory of European SME, 8. Frame, W. Scott, Aruna Srnvasan, and Lynn Woosley "The Effect of Credt Scorng on Small-Busness Lendng." Journal of Money, Credt, and Bankng, 33:3, pp Gal-or, Esther "Informaton Transmsson--Cournot and Bertrand Equlbra." The Revew of Economc Studes, 53:1, pp Greenbaum, S., G. Kanatas, and I. Veneza "Equlbrum Loan Prcng Under the Bank-Clent Relatonshp." Journal of Bankng and Fnance, 13: Harrngton, Joseph E., Jr "A Re-evaluaton of Perfect Competton as the Soluton to the Bertrand Prce Game." Mathematcal Socal Scences, 17:3, pp Jun, Byoung and Xaver Vves "Strategc ncentves n dynamc duopoly." Journal of Economc Theory, 116:2, pp Nakamura, L.I "Explorng the Checkng Account Hypothess." Journal of Retal Bankng, 3, pp Petersen, Mtchell A. and Raghuram G. Raan "The Effect of Credt Market Competton on Lendng Relatonshps." Natonal Bureau of Economc Research, Inc, NBER Workng Papers. 16

18 Raan, Raghuram G "Insders and Outsdes: The Choce between Informed and Arm s- Length Debt." Journal of Fnance, 47:4. Ramakrshnan, Ram T. S. and Anan V. Thakor "Informaton Relablty and a Theory of Fnancal Intermedaton." Revew of Economc Studes, 51:3, pp Saunders, Anthony Fnancal Insttutons Management. Boston. Schäfer, Dorothea "The New Basel Accord and ts Impact on Small and Medum-szed Companes." German Insttute for Economc Research - Economc Bulletn, 40, pp Sharpe, Steven A "Swtchng costs, market concentraton, and prces: the theory and ts emprcal mplcatons n the bank depost market." Fnance and Economcs Dscusson Seres, Vol Board of Governors of the Federal Reserve System (U.S.). Stgltz, Joseph E. and Andrew Wess "Credt Ratonng n Markets wth Imperfect Informaton." Amercan Economc Revew, 71:3, pp Udell, Gregory F "SME Lendng: Defnng the Issue n a Global Perspectve." Kelley School of Busness. Indana Unversty. Wagenvoort, Ren "Are Fnance Constrants Hnderng the Growth of SMEs n Europe?" EIB Papers, 8:2, pp World Bank "Can Interventon Work? The Role of Government n SME Success." World Bank Group: Washngton, DC. World Bank "Revew of Small Busness Actvtes." World Bank. World Bank Group: Washngton, DC. World Bank "Revew of Small Busness Actvtes." World Bank Group: Washngton, DC. 17

19 Fgure 1 loan nterest rate r * F1 bank a bank F2 margnal relatonshp lendng montorng costs market share

20 Fgure 2 a margnal relatonshp lendng montorng costs loan nterest rate r* F1a bank F1b bank margnal fnancal statement montorng cost market share

21 Fgure 3 a margnal relatonshp lendng montorng costs loan nterest rate bank r* F1b bank margnal fnancal statement montorng cost x* market share

22 Box 1: Lendng technques reconsdered In general, lendng can be categorzed nto at least four 10 dstnct lendng technques. These practces dffer manly by the usage and generaton of nformaton (table 1): Relatonshp lendng s based on the experence of a gven bank wth a specfc borrower and therefore on soft nformaton collected over tme. Hence, f fnancal data s lmted, relatonshp bankng s the technque of choce. Fnancal statement lendng s based on evaluatng nformaton from the frms fnancal statements. The decson to lend depends largely on the strength of the balance sheet and ncome statements. Snce SMEs face less legal requrements than large companes to publsh fnancal data, fnancal statement lendng s lkely to be the technque of choce n bank lendng to large frms (Udell 2004). In the case of asset-based lendng, credt decsons are prncpally based on the qualty of the avalable collateral. Ths type of lendng causes hgh montorng costs and requres hghqualty recevables and nventory avalable to pledge (Berger and Udell 1995, 1998, Boot 2000). That s why t s generally used as a substtute for relatonshp lendng f the term of the relatonshp s short. Small busness credt scorng s an adaptaton of statstcal technques used n consumer lendng. In addton to nformaton about the fnancal statements, the credtworthness and hstory of the owner s heavly weghted (Frame et. al. 2001). In practce, small busness credt scorng s mostly used for mcro enterprses (Saunders 2001) and s a substtute for fnancal statement lendng wth few montorng costs but a hgh possblty of wrong declaratons by the borrower. The most mportant characterstc of the frst type of lendng s that t s based on soft nformaton. Banks may acqure nformaton through the relatonshp by montorng borrower performance over tme under credt arrangements and/or through the provson of other servces such as depost accounts. In contrast to ths, the other three types of lendng are based on hard nformaton. Thus, the man dfference between these two groups of lendng s the avalablty of nformaton to competng banks. Relatonshp bankng s based on collectng nformaton over tme and therefore produces prvate nformaton that s only avalable to the specfc bank or to a bankng network. Snce ths nformaton cannot be nterpreted out of ths specfc context, the relatonshp-lendng bank gans an advantage over ts compettors. 21

23 Table 1: Lendng Technques Type of nformaton Effcency Approxmaton n the model Relatonshp lendng Fnancal statement lendng prvate nformaton about the frm and the owner standardzed fnancal reportng data depends on the tghtness of bankng relatonshp depends on the qualty of the avalable data decreasng montorng costs Type of nformaton soft nformaton: hard nformaton: Asset based lendng credt collateral no credt loss f credt volume s n the lmt of collateral value not modeled Credt scorng standardzed fnancal data of owner and frm depends on the qualty of the avalable data but can be only a proxy of fnancal nsght flat rate montorng cost hard nformaton: Source: authors. 22

24 Footnotes 1 In concentrated relatonshp-lendng markets, Petersen and Raan (1994) fnd that loan nterest rates declne less than n compettve markets because they are subsdzed n favor of young relatonshps. Ths supports somewhat Greenbaum et. al. (1989) and Sharpe (1990). 2 By engagng n long-term relatonshps, frms transmt nformaton about the company and ts proects to the bank and can therefore reduce loan nterest rate and collateral requrements (Alen, Sounders and Udell 1991; Nakamura 1993). Boot and Thakor (1994) demonstrate ths relatonshp n a theoretcal model wthout learnng effects. 3 An artcle smlar n sprt to ours s Raan (1992), whch dscusses the ncentve of frms to prevent banks from extractng surplus from them. 4 We assume that a part of the market x s served by bank and the other part ( 1 x) s served by bank. 5 It s assumed that the bank knows whch share of proects wll be successful, but does not know the probabltes of success of a sngle nvestment proect. The bank does not lend to proects whch are dentfed as bad (the bank lends to qφ dentfed good and ( q)( 1 φ ) 1 wrongly dentfed bad credtors) 6 Wth µ as the functon of possble nterest rates. 7 The Bertrand type competton does not lead to extreme outcomes because of nonhomogenety of montorng costs. However, f the Bertrand-competng banks prefer actvty, a reducton n loan nterest rate r* would lead to a margnal proft below margnal costs. We follow Bracoud (2002) n argung that even f banks prefer actvty, t does not lead to rratonal behavor n enhancng market share even f margnal profts are lower than margnal costs. 8 We wll get comparable results to ths case f we consder a credt-scorng bank alternatvely to the fnancal statement lendng bank. The only dfference between the two technques smply s a lower level of montorng effcency for the credt scorng bank: φcredtscorng < φfnancalstatement = φrelatonshplendng reconsder that φ s assgned as montorng effcency of banks. 23

25 9 Ths equlbrum s statc and does not hold for a dynamc case snce no new borrowers are served. In a dynamc case, t s suggested that the bank subsdzes new borrowers by lendng at the cost of old borrowers. 10 Mostly two lendng technologes are descrbed n lterature relatonshp lendng and transacton based lendng. For our purpose we follow Berger and Udell (2002) whch s a bank based vew rather than the broader sx technque vew n Udell (2004) who ncludes factorng and trade credt. 24