The Role of Collateral and Personal Guarantees in Relationship Lending: Evidence from Japan's Small Business Loan Market

Transcription

1 RIETI Dscusson Paper Seres 05-E-027 The Role of Collateral and Personal Guarantees n Relatonshp Lendng: Evdence from Japan's Small Busness Loan Market ONO Arto Mzuho Research Insttute UESUGI Ichro RIETI The Research Insttute of Economy, Trade and Industry

2 RIETI Dscusson Paper Seres 05-E-027 The Role of Collateral and Personal Guarantees n Relatonshp Lendng: Evdence from Japan s Small Busness Loan Market * Arto Ono Mzuho Research Insttute Ichro Uesug Research Insttute of Economy, Trade and Industry November 2005 Abstract Ths paper nvestgates the role of collateral and personal guarantees n small busness lendng usng the unque data set of Japan s small busness loan market. Consstent wth conventonal theory, collateral s more lkely to be pledged by rsker borrowers, mplyng they may be useful n mtgatng debtor moral hazard. Contrary to conventonal theory, we fnd that banks whose clams are ether collateralzed or personally guaranteed montor borrowers more frequently. We also fnd that borrowers who establsh long-term relatonshps wth ther man banks are more lkely to pledge collateral. Our emprcal evdence thus suggests that collateral and personal guarantees are complementary to relatonshp lendng. JEL classfcaton number: D82, G21, G30 Keywords: collateral, personal guarantees, relatonshp lendng * The vews expressed n ths paper are ours and do not necessarly reflect those of Mzuho Research Insttute nor Research Insttute of Economy, Trade and Industry (RIETI). We thank Tetsuro Furuta, Shnj Mzukam, Yutaka Soejma, Kotaro Tsuru, Noboru Yamada, semnar partcpants at Chuo Unversty, and the members of Corporate Fnance Study Group n RIETI for many helpful comments. Any remanng errors reman our responsblty.

3 1 Introducton Recent lterature on fnancal ntermedaton has focused on the role of banks as relatonshp lenders. Relatonshp lendng has also receved close attenton by polcymakers and the busness communty n Japan recently, followng publcaton of the Acton Program Concernng Enhancement of Relatonshp Bankng Functons by Japan s Fnancal Servces Agency n March The background paper of the Program argues that relatonshp bankng has not been workng effectvely n Japan and t ctes the ntensve use of collateral and personal guarantees n small busness lendng as a typcal example of Japanese banks ncompetence. The mplct assumpton n ths argument s that collateral and personal guarantees are ncompatble wth relatonshp lendng, whch requres ntensve screenng and montorng of borrowers on whom nformaton tends to be scarce and opaque. Ths assumpton s based on the wdely held vew that durng the bubble economy of the late 1980s when real estate prces were escalatng rapdly, Japanese banks reled too heavly upon the value of real estate collateral n makng loans to busnesses and hence lost ther screenng and montorng ablty. On the other hand, the conventonal wsdom among Japanese bankers s that banks do screen and montor borrowers more ntensvely followng the burstng of the bubble economy because they can no longer rely on the value of real estate collateral. If ths conventonal wsdom s true, collateral s lkely to be used as a tool for credt enhancement, whch may complement rather than substtute for screenng and montorng actvtes by banks. Ths paper studes the role and determnants of collateral and personal guarantees n relatonshp lendng usng the unque data set of Japan s small busness loan market. In partcular, we are nterested n whether the use of collateral and personal guarantees s n fact ncompatble wth screenng and montorng by the relatonshp lender. We argue that collateral and personal guarantees do play a postve role n relatonshp lendng. The ntensve use of collateral and personal guarantees n small busness lendng s not uncommon n other developed countres. For nstance, usng the 1993 Natonal Survey of Small Busness Fnances n the Unted States, Berger and Udell (1998) argue that most small busness loans are personally guaranteed by the busness owners and n many cases, the busness assets as well as the personal assets of nsders are explctly pledged as collateral to back the loan. A number of theoretcal and emprcal studes have examned the uses of collateral and personal guarantees n loan contracts. Gven asymmetrc nformaton between credtors and borrowers, collateral and personal guarantees may mtgate the problem of adverse selecton (Bester, 1985; 1987) and the problem of moral hazard (Bester, 1994; Boot, Thakor, and Udell, 1991). Collateral and personal guarantees also affect the ncentves of credtors, as they wll ether substtute for or complement nformaton producton by fnancal ntermedares (Manove, Padlla, and Pagano, 2001; Rajan and Wnton, 1995; Boot 2000; Longhofer and Santos, 2000). The presence of collateral and personal guarantees may also depend on the length and ntmacy of the relatonshp between credtors and borrowers (Boot, 2000; Boot and Thakor, 1994; Sharpe, 1990). The use of collateral and personal guarantees, how t relates to the characterstcs of borrowers and lenders, and the relatonshp between the two partes reman unclear; emprcal research has yet to reach decsve conclusons about the nature of ths relatonshp. Ths paper seeks to contrbute to the exstng lterature on collateral and personal guarantees usng the unque data set of Japan s small busness loan market. We are nterested n how the use of collateral and personal guarantees affects the ncentves of debtors, lenders, and the relatonshp between them. More specfcally, the paper examnes the followng three 1

4 conventonal theores. Frst, the paper examnes whether collateral and personal guarantees are requred for rsker borrowers n order to lmt the extent of debtor moral hazard after loans are made. Although t does not necessarly contradct the conventonal wsdom, some argue that collateral and personal guarantees are more lkely to be pledged by less rsky borrowers so as to prevent the problem of adverse selecton n loan contracts. We test both hypotheses n turn. Second, the paper nvestgates whether collateral and personal guarantees may substtute for the bank s nformaton producton actvtes, such as screenng and montorng of borrowers (the lazy bank hypothess). Contrary to ths conventonal theory, several theoretcal studes, whch we revew brefly below, argue that collateral and personal guarantees may nstead complement screenng and montorng actvtes by the lender. We emprcally assess whch hypothess holds n Japan s small busness lendng market. Thrd, we examne the correlaton between the use of collateral and personal guarantees and the closeness of the bank-borrower relatonshp. The current belef among Japanese polcymakers and busness leaders s that there s less use of collateral and personal guarantees f loans are based on sold relatonshps between lenders and borrowers. Ths belef s reflected n the Japan Fnancal Servces Agency s Acton Program. On the other hand, f collateral and personal guarantees are complementary to screenng and montorng by the relatonshp-lender, t would be natural to see the opposte correlaton. We also test these hypotheses. The paper s organzed as follows. Secton 2 revews theoretcal and emprcal lterature on collateral and personal guarantees n loan contracts. Secton 3 descrbes the data used n ths paper. Secton 4 presents our emprcal results. Frst, we take prelmnary overvews on how the rsk of the borrower, the degree of screenng and montorng by the lender, and the relatonshp between the two would affect the use of collateral and personal guarantees. Then, we present our estmaton models and emprcal results. Secton 5 summarzes our key fndngs. 2 Lterature revew on the role of collateral and personal guarantees 2.1 Role of collateral under perfect nformaton The role of collateral and personal guarantees dffers completely, dependng upon whether or not there s nformaton asymmetry between credtors and borrowers. To see ths pont, t s useful to consder frst the stuaton where credtors have perfect nformaton on borrowers. For convenence, we use the term collateral for both collateral and personal guarantees 1. The exposton s a smplfed verson of the semnal work by Bester (1985). We consder two types of rsk-neutral entrepreneurs, G and B, whose projects are dstngushed by ther rskness. Both projects requre the same amount of captal to carry out, and we assume the requred amount of captal s a unty. The returns to the projects are R and R ( R < R ) f they G B G B 1 To be precse, collateral s typcally physcal assets or securtes that the credtor can sell n the event of the borrower s default. In many cases, the assets or securtes pledged as collateral are owned by the borrowng frm (nsde collateral) and hence do not ncrease the potental losses that the borrower may suffer. Insde collateral manly defnes the order of senorty among credtors n the case of bankruptcy, although t also deters the use of perks by the borrower. On the other hand, a personal guarantee refers to a contractual oblgaton of the busness owner or other thrd partes, such as the relatves of the owner or drectors of the borrowng frm, to repay the prncpal n the event of a default. If the borrowng frm s a lmted lablty entty, a personal guarantee functons as outsde collateral, except that t does not gve control over specfc assets. Most of the theoretcal lterature, as well as our exposton below, explctly or mplctly assumes collateral s outsde, but t s often dffcult to dscrmnate between nsde and outsde collateral n emprcal analyses due to the lack of nformaton. 2

5 succeed and 0 f they fal. The probablty of success s gven by P G and P B ( P G > PB ), respectvely. Entrepreneurs fnance ther projects by borrowng from a bank whose loan contract s specfed by the nterest rate r and the amount of collateral C. Entrepreneurs face collateralzaton costs, whch are assumed to be proportonal to the amount of collateral by a factor k. For smplcty, there s only one rsk-neutral bank that gans all socal surpluses. The expected profts of an entrepreneur ( = G, B) are gven by: X = P ( R r kc ) (1 P )(1 + k) C (1) The expected profts of a bank for a loan contract wth entrepreneur are gven by: Z = P r + ( 1 P ) C (2) Because the bank s a monopolst, t wll set the terms of loan contracts to maxmze the expected proft, makng the expected proft of each entrepreneur zero. Because the bank can dstngush the rskness of borrowers under perfect nformaton, the bank wll charge dfferent nterest rates and mpose dfferent collateral requrements on each entrepreneur. If there s no collateral, the nterest rate s set at r = R and the bank wll earn P R ( X = 0 ). On the other hand, f the bank requres a postve amount of collateral C > 0, the nterest rate s set at (1 + k) C r = R + C and the bank wll earn P R kc. Hence, under perfect nformaton, P the bank wll not requre collateral. Ths result obtans because a socal cost accrues n regsterng and managng collateral. Alternatvely, the bank wll not requre collateral under perfect nformaton when there s no collateralzaton cost but entrepreneurs are rsk averse, because, from the vewpont of an entrepreneur, ncreasng the loss f the project fals by provdng collateral and ncreasng gan f the project succeeds by reducng nterest payments s ncompatble wth rsk-averseness (Bester, 1987). In other words, rsk-averse entrepreneurs would buy complete nsurance f there were actuarally far nsurance avalable. In the absence of such nsurance, an entrepreneur would prefer a loan contract wthout collateral as a second-best choce so as to mnmze the dfference between the payoff f the project succeeds and the payoff f the project fals. 2.2 Role of collateral under asymmetrc nformaton Rskness of the borrower The above result wll be qute dfferent f the bank cannot dscern the rskness of the entrepreneurs (hdden nformaton). Under nformatonal asymmetry, collateral can serve as a screenng devce n order to dscern the rskness of entrepreneurs. Ths follows from the observaton that the margnal rate of substtuton (wllngness to exchange nterest payment for collateral loss f default occurs) for the rsker entrepreneur s hgher (n absolute value) than that of the less rsky entrepreneur: MRS + k + P = 1 (3) P Hence, the lower-rsk entrepreneur G has a relatvely larger ncentve to pledge collateral than the rsky entrepreneur B, because of hs lower probablty of falure and loss of collateral. 3

6 The ncentve compatblty constrant requres the bank to offer the frst-best contract to the rsker entrepreneur, B, who has an ncentve to act as f he were type G. Hence, as s the case under perfect nformaton, the loan contract wth the rsker entrepreneur entals no collateral. Regardng the type G borrower, the bank wll offer a contract wth mnmum collateral 2 so as to satsfy to the followng ncentve compatblty constrant of the type B borrower: X ( r, C ) X ( r = R, C = 0) (4) B G G B B As a result, collateral serves as a screenng devce to dscrmnate based on the rskness of the borrower, and to mtgate the adverse selecton problem. The lower-rsk borrower wll choose the contract wth collateral, n order to take advantage of the lower nterest rate. On the other hand, when the nformaton asymmetry s n the form of hdden acton, n whch the lender cannot observe actons taken by a borrower after the loan s orgnated, collateral can be used as an ncentve to mtgate the moral hazard problem. For example, Boot, Thakor, and Udell (1991) argue that f a project s probablty of success depends on the degree of effort by the borrower whch s unobservable by the credtor and the margnal mpact of effort on the probablty of success decreases wth borrower qualty (that s, rsker entrepreneurs have a hgher margnal return to effort), then t s optmal for the lender to requre collateral from the rsker borrowers n order to lmt moral hazard (a lack of effort on the part of the borrower). Smlarly, Bester (1994) consders the stuaton where the credtors cannot drectly observe the project outcome and hence cannot dstngush whether the borrower defaults strategcally or because he s actually unable to meet hs debt oblgatons. Under ths constrant, collateral reduces the debtor s ncentve for voluntary default. Because n equlbrum the ncentve to strategcally default s negatvely correlated wth rsk, the rsker borrower s more lkely to be fnanced thorough loan contracts that ental collateral than the lower-rsk borrower. Contrary to the lterature on hdden nformaton, theoretcal models of hdden acton argue that the rsker entrepreneurs wll obtan loans wth collateral whle the less rsky ones obtan loans wthout collateral. One should note, however, that the theores of hdden nformaton, n whch the borrower s rsk s unobservable, and theores of hdden acton, n whch the borrower s rsk s observable but ts actons are unobservable, are not mutually exclusve because they are based on dfferent assumptons about the nformatonal structure. Screenng and Montorng by the lender Recent lterature on fnancal ntermedaton has focused on the role of banks as nformaton provders: that s, screenng the borrower s project and montorng ts performance. Manove, Padlla, and Pagano (2001) argue that, from the banks pont of vew, collateral can be consdered a substtute for evaluaton of the actual rsk of a borrower. Thus, banks that are hghly protected by collateral may perform less screenng of the projects they fnance than s socally optmal (the lazy bank hypothess). Ths dea s reflected n the Fnancal Servces Agency s Acton Program, whch urges banks to promote lendng actvtes [by] placng emphass upon cash flow from busness operatons and by avodng excessve dependence upon collateral and guarantees. B B 2 In our settng, ths reduces to C G PB PG ( RB RG ) =. The nterest rate for the type G borrower s set (1 + k)( P P ) G PB ( RB RG ) PG at rg = RG 1, whch s lower than the frst-best nterest rate (wthout PG PB 1+ k collateral) under perfect nformaton. Note also that t s lower than the nterest rate charged to the type B borrower. B 4

7 However, several theoretcal studes argue that collateral may complement screenng and montorng actvtes by the lender. For nstance, n the presence of other clamants, the lender s ncentve to montor the borrower s reduced due to the nformatonal free-rder problem, among others. In order to enhance the lender s ncentve to montor, loan contracts must be structured n a way that makes the lender s payoff senstve to the borrower s fnancal health. Rajan and Wnton (1995) argue that collateral may serve as a contractual devce to ncrease the lender s montorng ncentve, because collateral s lkely to be effectve only f ts value can be montored. Moreover, the use of collateral as an ncentve wll be more extensve when the value of such collateral deprecates rapdly accordng to busness condtons (e.g., accounts recevable and nventores), than when the value of collateral s relatvely stable 3 (e.g., real estate). As a corollary, Rajan and Wnton also show that f the value of collateral s too hgh relatve to the lender s clam, the lender has no ncentve to montor because ts clam s fully secured regardless of the borrower s busness condtons. The paper by Longhofer and Santos (2000) provdes another explanaton of how collateral may be complementary to screenng and montorng by banks. They pont out that banks usually take senor postons on ther small busness loans. They further argue that the relatonshp-lendng equlbrum, n whch the lender establshes frm bank-frm relatonshps by nvestng n costly nformaton producton actvtes such as screenng and montorng, s more lkely to exst when the relatonshp-lender (the bank) s senor to the frm s other credtors, because the lender s ncentve to make such nvestments depends crucally on ts payoff. If the bank s junor to other credtors, t gans lttle from addtonal nvestment n nformaton producton actvtes on the frm durng tmes of poor performance, and hence has lttle ncentve to make such nvestments. By makng ts loan senor to other credtors clams, the bank s able to reap the benefts of ts relatonshp-buldng nvestments. Because takng collateral effectvely rases the lender s prorty, ths argument can easly apply to the use of collateral. Relatonshp between the borrower and the lender Banks and frms often mantan ther relatonshp through multple nteractons over tme and across products. Such relatonshps often nvolve borrower-specfc nformaton gathered by the bank through screenng and montorng. Ths nformaton s thus propretary and exclusve n nature. As a result, the borrower tends to mantan relatons wth only one bank. Ths type of lendng s referred to as relatonshp bankng 4 (Boot, 2000). By establshng a sold relatonshp wth the borrower, the lender learns about the hdden attrbutes and actons of the borrower and reduces the nformaton asymmetry. Hence the terms of loan contracts may become more favorable to the borrower f the frm has transactons wth a specfc relatonshp-lender over tme. For example, Boot and Thakor (1994) construct a model n whch collateral requrements are negatvely correlated wth the duraton of bank-borrower relatonshp: Borrowers pledge collateral early n the relatonshp but do not pledge collateral after they have demonstrated success wth several projects. 3 Another related beneft of usng nventores and accounts recevable as collateral s that they may reveal valuable nformaton about the busness (Boot, 2000). Ths also shows the complementartes between collateral and nformaton producton by the fnancal ntermedary. 4 Relatonshp lendng s qute dfferent from transactons-based lendng, where a lender focuses on a sngle transacton and hence mantans an arm s-length relatonshp wth a borrower. In the realm of small busness lendng, Berger and Udell (2002) cte fnancal statement lendng, asset-based lendng, and credt scorng lendng as three forms of transactons-based lendng. 5

8 Alternatvely, relatonshp lendng may enhance the use of collateral due to the hold-up problem: As the bank obtans the propretary nformaton about the borrower, the bank exerts ts nformaton monopoly by chargng hgher nterest rates or requrng more collateral (Sharpe, 1990). In contrast, the strand of lterature that emphaszes the complementartes between collateral and screenng and montorng actvtes by the lender dscussed n the prevous subsecton argues that collateral s an ntrnsc component of relatonshp lendng. Ths lterature treats collateral as a necessary condton for the lender to nvest n nformaton producton. Boot (2000) hghlghts another contrbuton of collateral n relatonshp lendng: ts role n mtgatng the soft-budget constrant problem. The soft-budget constrant problem refers to a stuaton where the lender has dffculty n enforcng the loan contracts that may come wth relatonshp lendng. For example, consder the case where a borrower n dffculty asks the bank for more credt and reduced nterest oblgatons n order to avod default. Although a transacton-based lender would not lend to such a borrower, a relatonshp-lender that has already made loans mght extend addtonal credt and lower the nterest rate n the hope of recoverng ts prevous loan. Once the borrower realzes he can renegotate the loan contract relatvely easly, he has an ncentve to msbehave ex ante, such as by falng to make suffcent efforts to prevent the bad outcome (dynamc nconsstency). In such cases, collateral wll ncrease the ex-post barganng power of the lender and hence mtgate the soft-budget constrant problem because collateral makes the value of lender s clam less senstve to the borrower s total net worth. The bank can credbly threaten to call n the loan and thus prevent msbehavor by the borrower. 2.3 Emprcal evdence Because collateral has lttle role under perfect nformaton, most emprcal lterature on collateral nvestgates the role of collateral under asymmetrc nformaton. Ths subsecton revews some of these emprcal studes. Rskness of the borrower There are several emprcal studes that examne the relatonshp between collateral and the rskness of the loan or the borrower. Berger and Udell (1990) nvestgate the relatonshp between collateral and credt rsk by estmatng the dfferences n rsk premums between secured and unsecured loans. If collateral serves as an ncentve devce that s desgned to solve the problem of adverse selecton, then the rsk premum of the loan should be negatvely correlated wth the lkelhood of collateral beng pledged because a low-rsk borrower would choose a contract wth collateral, n order to take advantage of the lower rsk premum. On the other hand, f the lender observes the ex-ante rsk of the borrower and requres a hgher-rsk borrower to pledge collateral, then there should be a postve relatonshp between the rsk premum and the presence of collateral. Berger and Udell (1990) fnd a postve assocaton between use of collateral and rsk premums, whch s consstent wth the hypothess that collateral reduces debtor s moral hazard. Smlarly, Berger and Udell (1995) fnd a postve relatonshp between the leverage of the borrower, whch s a proxy for borrower rsk, and collateral, and thus confrm ther earler result. Pozzolo (2004) focuses on possble dfferences between the roles of nsde and outsde collateral (see footnote 1 for the defnton of these terms). He argues that outsde collateral s more effectve n dealng wth debtor ncentve problems because t ncreases the value of assets that the lender can wthhold n the event of default. Because t s dffcult n practce to dstngush between nsde and outsde collateral due to data lmtatons, the study consders collateral (such 6

9 as physcal assets or equtes) as nsde and personal guarantees as outsde. Pozzolo (2004) uses a credt score, whch measures the rsk profle of the borrower, as a proxy for ex-ante borrower rsk. The study fnds no statstcally sgnfcant relatonshp between collateral and borrower rsk and nterprets ths result as potentally consstent wth the dea that collateral mtgates the adverse selecton problem, whch deals wth the unobservable rskness of the borrower. The study also argues that collateral s not used as an ncentve devce for the moral hazard problem, presumably because such collateral s nternal to the borrowng frm. The dea that nternal collateral cannot serve as an ncentve s supported by Elsas and Krahnen (2000), who fnd no statstcally sgnfcant relatonshp between collateral and borrower qualty. 5 In the case of personal guarantees (outsde collateral), Pozzolo (2004) fnds postve assocaton between the two, mplyng that personal guarantees are used as an ncentve n the presence of moral hazard. The study by Jménez, Salas-Fumás, and Saurna (2004) drectly tests the adverse selecton hypothess and the moral hazard hypothess by separatng the ex-ante and ex-post measures of borrower rskness. The ex-ante rskness of the borrower, whch must be dstngushed to examne moral hazard hypothess, s measured by a default dummy varable that takes the value of one f the borrower had prevously defaulted on a loan at the tme the new loan was made. As for the ex post-rskness of the borrower, whch s used to test the adverse selecton hypothess, the default varable takes the value of one f the borrower defaults on a loan after t s made. The authors fnd evdence supportng the moral hazard hypothess. Brck, Kane and Pala (2004) obtan a smlar result, usng a default dummy varable for ether the prncpal owner or the frm as a measure of the ex-ante rskness of the borrower. Screenng and Montorng by the lender To our knowledge, lttle work has been done to emprcally assess whether the use of collateral and personal guarantees are substtutve or complementary to screenng and montorng by the lender. Based on the lazy bank hypothess, whch posts collateral as a substtute, Jménez, Salas-Fumás, and Saurna (2004) examne whether banks wth a lower level of expertse n small busness lendng use collateral more ntensvely. Examnng Spansh loan data from 1984 to 2002, they fnd that loans orgnated by smaller banks, whch are deemed to have fewer resources for credt evaluaton, and by savngs banks, whch tradtonally make loans manly to households rather than busnesses, are more lkely to extend collateralzed loans. The authors argue that ther fndngs suggest collateral s used as a substtute for the evaluaton of credt rsk, and hence s compatble wth the lazy bank hypothess. Relatonshp between the borrower and the lender A vast amount of emprcal work has nvestgated how the relatonshp between a borrower and a lender may affect the terms of small busness lendng, such as nterest rates, maturty, and collateral requrements. The proxy varables for relatonshp vary n the lterature, such as the duraton of the lender-borrower relatonshp, the number of fnancal products the borrower purchases from the lender ( scope of relatonshp), and the number of banks wth whch the borrower has transactons. As wth the theoretcal lterature, the emprcal results n the above studes are contradctory. Berger and Udell (1995), Brck, Kane, and Pala (2004), Harhoff and Körtng (1998), and Jménez, Salas-Fumás, and Saurna (2004) fnd negatve relatonshps between the duraton of 5 Elsas and Krahnen (2000) argue that ther emprcal results nether support the role of collateral as a sgnalng devce n the presence of adverse selecton nor as an ncentve devce n the presence of moral hazard. 7

10 the bank-frm relatonshp and the probablty that collateral wll be pledged. These fndngs are consstent wth the model of relatonshp bankng and reputaton posted by Boot and Thakor (1994). Berger and Udell (1995) and Harhoff and Körtng (1998) also fnd the nterest rate on loans falls wth the duraton of relatonshp. But Brck, Kane, and Pala (2004) argue that ths result may be due to the endogenety problem among loan contract terms; they fnd that endogenzng collateral and fees elmnates any sgnfcant correlaton between the nterest rate and the duraton of the relatonshp. Degryse and Van Cayseele (2000) also fnd a negatve relatonshp between the nterest rate and the duraton of the relatonshp, but ther paper argues ths result depends on the proxes used for the relatonshp: They obtan a postve relatonshp between the scope of lender-borrower relatons and the collateral requrement, mplyng that a relatonshp lender wll requre more collateral than a transacton-based lender, presumably because of the hold-up problem. As for the emprcal lterature that analyzes the number of banks nvolved n transactons, Harhoff and Körtng (1998) fnd the ncdence of collateralzaton of credt lnes ncreases as the number of fnancal nsttutons the frm s borrowng from rses. They argue that concentrated borrowng represents a strong lender-borrower relatonshp, and that ther results provde evdence for the clam that such a relatonshp eases loan condtons for the borrower. On the other hand, Jménez, Salas-Fumás, and Saurna (2004) fnd that the use of collateral decreases wth the number of fnancal nsttutons used by the borrower. Interestngly, they nterpret the number of lenders as an ncrease n the barganng power of the borrower, and hence reach the same concluson qualtatvely as Harhoff and Körtng (1998). Petersen and Rajan (1994) provde anecdotal evdence from conversatons wth U.S. bankers that concentrated borrowng mples a strong relatonshp. In contrast to the lterature above (except Degryse and Van Cayseele (2000)), Elsas and Krahnen (2000) and Pozzolo (2004) obtan results consstent wth the dea that relatonshp lenders do requre collateral more frequently than other lenders because of the postve role such collateral plays n relatonshp lendng. Usng survey data from German banks, Elsas and Krahnen fnd that housebanks, defned as relatonshp-lenders, have a hgher probablty of holdng loans backed by collateral and personal guarantees than other banks. Pozzolo (2004) fnds a postve relatonshp between the term of the loan and the probablty of collateralzaton. He fnds, however, a negatve relatonshp between loan term and the probablty of the loan beng secured by personal guarantees. 3 Data We use data from the Survey of Corporate Procurement (2001), the Survey of the Fnancal Envronment (2002), and the Survey of the Corporate Fnancal Envronment (2003) conducted by the Small and Medum Enterprse Agency of Japan (collectvely referred to as SFEs herenafter). In each of these surveys, a questonnare was sent to a total of 15,000 companes, manly small and medum-sze enterprses (SMEs herenafter), of whch around 7,000 to 9,000 frms responded each year. Although the contents of the SFEs vary from year to year, the surveys ask a number of detaled questons regardng frm characterstcs and fnancal transactons such as the number of fnancal nsttutons the frm deals wth; ts relatonshp wth ts man bank (an obvous canddate for the relatonshp-lender); whether loans are secured by collateral, personal guarantees, or government-sponsored credt guarantees; and nterest rates charged on short-term loans. Because we are nterested n the role of collateral and personal guarantees n small busness lendng, we restrct our sample to SMEs, that s, enterprses wth 8

11 captal of no more than 300 mllon yen or no more than 300 regular employees. Unless otherwse stated, we use the 2002 SFE, whch provdes the most detaled nformaton on the use of collateral and personal guarantees. We also use the TSR (Tokyo Shoko Research) database, whch conssts of fnancal statements of SMEs, and we match the data obtaned from the TSR wth that from the SFE. The TSR database also provdes credt scores for the frms, and we use ths varable as a proxy for the borrower s credt rsk. The score ranges from 0 to 100 ponts, wth a hgher credt score mplyng a lower credt rsk for the frm. The score conssts of four components: () management ablty such as the busness experence of the manager and outstandng assets that can be collateralzed (20 ponts); () growth potental of sales and profts (25 ponts); () stablty factors such as frm age, amounts of captal, past payment and credt hstory of the frm (45 ponts); and (v) reputaton and dsclosure (10 ponts). Based on the total credt score, the frm s judged as ether requrng no cauton (80-100), safe (65-79), requrng lttle cauton (50-64), requrng some cauton (30-49), or requrng cauton (less than 30). The score s subjectve n the sense that each researcher of the TSR grades the frms for whch he s responsble. It should also be noted that the absolute values of the scores may be of lttle value n some cases because researchers are asked to assgn a score of 50 ponts to the average frms wth whch they are workng. Despte these shortcomngs, the TSR credt score s vewed as a typcal metrc of credt rsk for SMEs n Japan and we use the score wth care. Table 1 shows the medan values of several varables for the 2002 SFE, dependng on whether the frm pledges collateral, personal guarantees, or has government sponsored credt guarantees on ts loans from the man bank. As shown n the last row, the medan amount of captal for frms surveyed s over 2 mllon yen and the medan number of employees s 36, whch mples that our sample conssts of relatvely large SMEs. 6 Note also that the standard devaton of each varable s farly large; thus we report the medan rather than the average n the table. Table 1 reveals that frms whch pledge collateral or personal guarantees, or roughly three-fourths of the sample, are typcal SMEs n our sample n terms of sze, credt rsk, and several fnancal ratos. Frms recevng credt guarantees, whch account for about half the sample, are relatvely smaller and deemed rsker than the others. They are thus subject to hgher nterest rates. Composton of collateral and personal guarantees Tables 2 and 3 show the composton of collateral by type of assets pledged and the composton of guarantors, respectvely, usng 2001 SFE data. The fgures do not add up to 100% because more than one response s allowed. Table 2 confrms the wdely held vew that Japanese SMEs most often pledge real estate as collateral. Fnancal assets such as deposts, shares, and commercal blls are the second most common form of collateral and are especally common among the low-score (hgh-rsk) frms. Account recevables and nventores, whch are typcal assets pledged for workng captal n the Unted States, are rarely used. The table does not dstngush between nsde and outsde collateral 7. Table 3 shows that the representatve of the frm s the guarantor n most cases. In addton, drectors other than the representatve and relatves of the representatve occasonally guarantee loans, especally for low-score frms. Clearly, personal guarantees serve as outsde collateral. 6 The average number of employees for all SMEs was seven, accordng to the Mnstry of Internal Affars and Communcatons, Establshment and Enterprse Census n Japan See footnote 1 for the defnton of nsde and outsde collateral. Our conversatons wth Japanese bankers suggest that small busness owners personal assets are pledged as collateral n some cases. 9

12 4 Emprcal Results 4.1 Varables The terms of the loan contracts we analyze are whether the borrower pledges collateral and/or personal guarantees to ts man bank, and the short-term nterest rate charged by the man bank. 8 The varable COLL and GUAR are 0/1 varables that take the value of 1 f the borrower pledges collateral/personal guarantees to ts man bank. The varable RATE ndcates the short-term nterest rate as of end of October 2002, n tenths of a bass pont (.e., 1000 ndcates 1.000%). We have grouped our explanatory varables nto three classes: rskness of the borrower, screenng and montorng by the lender, and the relatonshp between the borrower and the lender. The rskness of the borrower s approxmated by several varables that help capture the rsk profle of the borrower. The varable SCORE ndcates the TSR credt score explaned above. Other than SCORE, we use a number of fnancal ratos such as LEV (leverage rato,.e., debt outstandng/total assets outstandng), PROFMARG (proft margns,.e., profts before tax/gross sales), CASHRATIO (cash rato,.e., cash holdngs/gross sales), and LOGSALES (the logarthm of sales). The 2002 SFE asks respondent frms how often they have contact wth the loan offcers of ther man banks, whether they submt relevant documents such as fnancal statements and cash flow forecast tables to ther man banks so that banks can assess borrowers credt rsks, and f so, how often. Hence, screenng and montorng actvtes by lenders are captured by the varables DOC, DOCFREQ, CONTACTFREQ. The 0/1 varable DOC takes the value of 1 f the borrower submts documents to ts man bank, and the ndex varable DOCFREQ shows the frequency, wth the lowest value 1 ndcatng the shortest frequency (1: once every 1-2 months, 2: quarterly, 3: sem-annually, 4: annually). Smlarly, the ndex varable CONTACTFREQ ndcates the frequency of loan offcer contact and takes the value of 1-9 (1: every day, 2: weekly, 3: once every 2 weeks, 4: monthly, 5: b-monthly, 6: quarterly, 7: sem-annually, 8: annually, 9: no contact). We also use the rato of non-performng loans to total loans, NPL, as an ex-post measure of screenng and montorng actvtes by the lender. We assume that the bank s non-performng loan rato s negatvely correlated wth the ntensty of ts screenng and montorng efforts. Fnally, we use the followng lender-borrower relatonshp varables: DURATION, whch ndcates the duraton of the man bank-borrower relatonshp, SCOPE, whch ndcates the number of fnancal products the borrower purchases from ts man bank ( scope relatonshp), and BANKS, whch ndcates the number of banks wth whch the borrower has transactons 9. Smlar to the defnton of housebanks n Elsas and Krahnen (2000), the defnton of a man bank n the SFE s somewhat subjectve because each respondent frm s asked to choose ts man bank based on ts own perceptons. As for the number of fnancal products purchased, the 2002 SFE asks frms to lst all products, other than loans, whch they purchase from the man banks. We then tabulate the number of products that each frm has purchased If the borrower has several short-term loans wth ts manbank, the loan wth the hghest nterest rate s reported. 9 We also construct an ndex varable, BANKONE, whch takes the value of 1 f the borrower has a sole transacton wth ts man bank. 10 We exclude the tems purchasng addtonal stock of the manbank and hrng retred bankers, 10

13 Table 4 lsts the varables used n our emprcal analyss and ther defntons. Several unexplaned varables wll be dscussed below. 4.2 Prelmnary fndngs on the role of collateral and personal guarantees Before explanng our regresson models and results, t s useful to provde a prelmnary overvew of how the rskness of the borrower, the degree of screenng and montorng by the lenders, and the relatonshp between the two affects the share of borrowers who use collateral and personal guarantees. Rskness of the borrower As stated above, we use the TSR credt score as a measure for ex-ante rsk of the borrower. Table 5 shows the percentage of borrowers usng collateral, the percentage of those usng personal guarantees, and the average short-term nterest rates (RATE) pad by collateral/guarantee-user and non-users, by credt score category (SCORE). Table 5 ndcates a negatve relatonshp between credt score and use of collateral and personal guarantees, and thus favors moral hazard hypothess. Interestngly, even wthn the same credt score category, borrowers who pledge collateral and personal guarantees are charged hgher nterest rates than those who do not. Ths s consstent wth the fndng n Berger and Udell (1990), who argue rsker borrowers more often pledge collateral, but that recourse to collateral less than fully offsets the dfference n borrower rsk. The nterest rate dfferental between the two s especally large for low-score (hgh-rsk) borrowers. We also nvestgate whether there are any prelmnary fndngs consstent wth the adverse selecton hypothess. Frst, followng the model of Jménez, Salas-Fumás, and Saurna (2004), we look nto the amount of collateral pledged. The 2002 SFE provdes a value ndex of collateral, whch measures the present value of collateral relatve to the amount of debt ncurred. Table 6 shows that, once the decson has been made to pledge collateral, t s the hgh-score (low rsk) borrowers who pledge more, suggestng the plausblty of the adverse selecton model. However, we attrbute ths fndng to the smple fact that the low-score borrowers often do not have enough assets to fully secure the loan. The bottom row of Table 6 shows the rato of borrowers who own real estate whose value exceeds the amount of short-term and long-term loans. 11 Naturally, the percentage rses along wth the score of the borrowers. Second, we examne the relatonshp between the share of borrowers usng collateral and personal guarantees n year 2001 and the TSR credt score n 2002 (Table 7). Because the credt score n 2002 s unobservable by the lender n 2001, we thnk ths s a more approprate way to test whether the lender uses collateral and personal guarantees to deal wth the problem of adverse selecton, under whch the borrower s rskness s unknown. Table 7 ndcates, however, that the relatonshp between the share of borrowers usng collateral and personal guarantees and the credt score a year after the loan s made s stll negatve, whch s nconsstent wth the adverse selecton hypothess. whch appear rrelevant to buldng the relatonshp. 11 We use the value of real estate because ths s the most common asset pledged as collateral n Japan (Table 2). We have also compared the results aganst the value of other assets that can be collateralzed, such as securtes, and cash. The result s effectvely the same. 11

14 Screenng and montorng by the lender One mportant new approach n ths paper s our use of drect measures for screenng and montorng actvtes by lenders n our examnaton of the relatonshp between use of collateral and personal guarantees and screenng and montorng. Because t s somewhat subjectve to post a pror whch type of lenders have a relatve advantage n evaluatng and managng credt rsks of small busness borrowers (as was done by Jménez, Salas-Fumás, and Saurna, 2004), our work may shed lght on how collateral may affect the screenng and montorng ncentves of the lender. Table 8 shows the relatonshp between the frequency of document submsson (DOCFREQ) and the use of collateral and personal guarantees, and average short-term nterest rates 12. Because the use of collateral and personal guarantees and the average short-term nterest rate are affected by borrower rsk, we make observatons by credt-score category (the rows n Table 8). In general, the hgher the percentage of loans wth ether collateral or personal guarantees, the more often borrowers submt documents. Ths prelmnary result s nconsstent wth the lazy bank hypothess, whch clams that a bank requres collateral as a substtute for screenng and montorng. Interest rates are somewhat hgher for borrowers who submt documents more frequently. We make a smlar tabulaton to nvestgate whether banks that contact ther borrowers more often (CONTACTFREQ) are more lkely to have loans wth collateral and personal guarantees (table not reported), and obtan qualtatvely the same result as above. We also examne the relatonshp between the non-performng loan rato (NPL) and use of collateral and personal guarantees, because NPL may serve as an ex-post measure for screenng and montorng actvtes by the lender. We have found, however, no monotonc relatonshp between the two (table not reported). Relatonshp between the borrower and the lender Table 10 shows the relatonshp between the duraton of the man bank-borrower relatonshp (DURATION) 13 and the use of collateral and personal guarantees, and the average short-term nterest rate. As the duraton ncreases, the share of collateralzed and personally guaranteed loans rses. Note also that the collateral rato s relatvely low for borrowers wth man bank relatonshps of less than 15 years, regardless of credt score. Ths suggests collateral and personal guarantees are complementary to the relatonshp, and s consstent wth both the hold-up argument (the dark sde of the relatonshp) and the mtgaton of the soft-budget constrant argument (the brght sde of relatonshp). Interest rates are somewhat lower for borrowers wth longer man bank relatonshps, but the correlaton s less clear-cut. The fndng on nterest rates s thus nconsstent wth the hold-up hypothess. Tables 11 and 12 make smlar observatons for the number of fnancal products purchased by the borrower from ts man bank (SCOPE) and the number of banks the borrower has 12 We have also nvestgated the frequency of document submsson (DOCFREQ) by each bankng sector and checked whether a partcular bankng sector montors the borrowers more frequently (Table 9). Table 9 shows that the montorng frequency of Shnkn (credt unons) and Shnkum (credt cooperatves) are slghtly shorter than the other bankng sectors, because ther shares of low-score borrowers that requre ntensve montorng are larger than those of the other sectors. Hence, controllng for the effect of borrower rsk, we do not fnd any relatonshp between the bankng sector and montorng frequency. Ths renforces our emprcal strategy of not postng a pror whch type of lenders have a relatve advantage n evaluatng and managng credt rsks of small busness borrowers. 13 Each respondent frm s asked to state the exact number of years t has been dealng wth ts manbank. 12

15 transactons wth (BANKS). Table 11 leads us qualtatvely to the same results as above: Borrowers wth more scope n the relatonshp are more lkely to pledge collateral and personal guarantees, and make slghtly lower nterest payments (although the relatonshp s less clear). Table 12 gves a somewhat dfferent vew of the lender-borrower relatonshp. It shows that borrowers who establsh propretary (sole) relatonshps wth ther man banks pledge collateral and personal guarantees less often than those who do not. In the case of collateral, whch s more lkely to be nsde than personal guarantees, ths prelmnary evdence supports the dea that the man reason for requrng borrowers to pledge collateral s to secure senorty for the man bank s clams, because the need to defne senorty among credtors would be less n the case of a sngle transacton. 4.3 Regresson model and results We estmate the followng equaton to verfy whether collateral and personal guarantee requrements are greater for rsker borrowers, for banks wth more ntensve montorng actvtes, and for borrowers wth more ntmate bankng relatonshps: Pr( Yj = g) = f ( RISK j, MONITORING, RELATION j, FIRM j, LENDER, CONTRACTS j, OTHERS) where Y j equals 1 f the loan made by bank to the borrowng frm j s collateralzed or personally guaranteed. RISK j s a vector of varables specfyng the rsk profle of the borrower. MONITORING s a vector of varables of montorng actvtes by banks. RELATION j s a vector of varables ndcatng the bank-frm relatonshp. All of these varables are dscussed n Table 4. FIRM j and LENDER are dummy varables for frm and lender characterstcs, where FIRM j ndcates the ndustry the frm belongs to and LENDER ndcates the sector (such as cty bank or regonal bank) that the bank belongs to. Fnally, we control for the contractng terms (CONTRACTS j ) such as nterest rate, RATE j, and whether the borrower pledges a guarantee or collateral to ts man bank. These varables are potentally endogenous, and we dscuss how we deal wth the problem of endogenous regressors below. The varables n OTHERS nclude several varables that are specfcally mportant determnants for collateral and personal guarantees. For example, the varable MATURITY j whch represents the rato of short-term loans to long-term loans s lkely to be correlated wth whether the loan s collateralzed because long-term loans such as equpment lendng and real estate lendng are more lkely to be secured by physcal assets to be held by the borrower. The equaton above s estmated usng probt specfcaton for both collateral and personal guarantees. As n Berger and Udell (1990), we also estmate the followng nterest rate equaton as an ndrect test for the determnants of collateral and personal guarantees. RATE j = f ( RISK, MONITORING, RELATION, FIRM, LENDER, Y, OTHERS) j j j j In partcular, f a borrower who establshes a sold relatonshp wth ts man bank s more lkely to pledge collateral and personal guarantees, the nterest rate equaton verfes whether the complementarty between collateral and personal guarantees and the bank-frm relatonshp s due to the hold-up problem or to mtgaton of the soft-budget constrant. 13

16 Estmaton strateges We begn wth the probt estmatons for collateral and personal guarantees, and the OLS estmaton for the nterest rate, assumng that the contract-terms are exogenous explanatory varables. For example, regardng the probt estmaton for collateral, the nterest rates and the bnary varable for personal guarantees are assumed to be exogenous. We then mplement the probt estmatons for collateral and personal guarantees, treatng nterest rates as an endogenous varable. The estmaton wll follow the maxmum lkelhood estmaton procedure wth the endogenous varable n Wooldrdge (2004, pp ). The dea s to obtan the parameters of the model and ther standard errors by maxmzng the lkelhood functon of the followng equaton: f ( Y, RATE z) f ( Y RATE, z) f ( RATE z) j = j where z s a vector of nstrumental varables. As shown n the second term of the rght-hand sde equaton, nterest rates (endogenous varable) are estmated by the nstrumental varable. The nstrumental varables of nterest rates are measures of market power and the age of the borrowng frm (FIRMAGE). We use the Herfndahl Index for small busness lendng n the prefecture of the frm, denoted as HHI, as our market power measure. Because HHI s computed based on the share of small busness lendng of regonal banks, second-ter regonal banks, Shnkn (credt unons), and Shnkum (credt cooperatves), we also nclude the aggregated share of cty banks n small busness lendng n the prefecture of the frm (CITYSHARE). These market power varables are taken from the Knyu Journal, Regonal Fnance Map. The nformaton obtaned from the nterest rates equaton as well as nformaton from the collateral (personal guarantees) equaton s smultaneously used n estmatng the parameters. It may be preferable to endogenze personal guarantees (collateral) as well as nterest rates n estmatng the probablty of collateral (personal guarantees) pledged. However, the number of endogenous varables that we can handle n the full maxmum lkelhood procedure s constraned by the computatonal dffcultes n gettng the teratons to converge. Alternatvely, we follow the two-stage condtonal maxmum lkelhood method (Wooldrdge, 2004, pp ), n whch the nterest rates and personal guarantees (collateral) are estmated by ordnary least squares wth nstrumental varables n the frst step, and then the probt model for collateral (personal guarantees) s estmated n the second step, usng the ftted values and the standard errors obtaned n the frst-step estmatons. The nstrumental varable used n the frst-step estmaton for personal guarantees s the share of equty holdngs held by the owner and hs relatves n the prevous year, 2001: the ndex varables OWNERRATIO take the value of 1-7, wth the hghest value 7 ndcatng the 100% equty holdngs (1: 0%, 2: 1-5%, 3: 6-25%, 4: 26-50%, 5: 51-74%, 6: 75-99%, 7: 100%). The nstrumental varable for collateral s the rato of real estate holdngs to total assets (LANDRATIO). Based on these three types of estmatons, we wll make our nference on how the rskness of the borrower, the degree of screenng and montorng by the lenders, and the relatonshp between the two affects the share of borrowers who use collateral and personal guarantees. Estmaton results Tables 13, 14, and 15 report our estmaton results for collateral, personal guarantees, and nterest rates equatons, respectvely. The frst column of each table provdes the estmates of the benchmark models n whch all the terms of loan contracts are assumed to be exogenous. 14