When Arm’s Length is Too Far

In the wake of the global financial crisis, policy-makers’ attention has focused on lending to small and medium-sized enterprises (SMEs) as these were among the most affected firms when the credit cycle turned. SME finance has also attracted the attention of the G20 as it is seen as an important constraint on firm growth in developing, emerging and industrialized countries. Indeed, a joint report by IFC and McKinsey has pointed to a global SME financing gap of over 2 trillion USD (Stein, Goland and Schiff, 2010). Various initiatives, such as the SME Finance Challenge and the SME Finance Forum, have consequently been established to try to alleviate small firms’ funding constraints.

But what is the best way for banks to reach out to SMEs: long-term relationship based lending or more cost-effective transaction lending, based on collateral and hard information?  In recent research (Beck, Degryse, De Haas and Van Horen, 2014), we show that relationship lending can be especially helpful during a credit crunch, such as experienced by the countries in central and eastern Europe and the Caucasus during the global financial crisis.   

While the traditional literature has focused on relationship lending as the prime lending tool for SMEs, recent evidence has shown that transaction-based or arms-length lending – using hard information and assets as collateral – can be more cost-effective and allows larger and non-local banks to lend to SMEs. Research using cross-country bank-level surveys or credit-registry data from Bolivia has indeed shown that both lending techniques can work to cater to SMEs’ financing needs (Beck, Demirguc-Kunt and Martinez Peria, 2011; Beck, Ioannidou and Schäfer, 2012).

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While these papers exploit cross-sectional variation in lending techniques, there is little evidence so far on the effectiveness of different lending techniques across the credit cycle. To fill this gap, we combine firm-level survey data (BEEPS survey) for 2005 and 2008/9 across 21 transition economies with new data based on face-to-face interviews with 400 bank CEOs (BEPS II survey), whose banks make up about 80 percent of the banking sector across these countries. We also merge these data with newly collected, detailed information on branch locations. We then use this dataset to gauge the effectiveness of relationship and transaction-based lending in alleviating firms’ financing constraints during the boom and the bust years.
In particular, we combine these datasets to construct

  • An indicator of financing constraints, based on information on whether a firm has a loan (demand and unconstrained), has no loan and no need for one (no demand and thus unconstrained) or has no loan, because its application was rejected or it was discouraged from applying (demand and constrained).  This three-way classification allows us to control for demand-side effects when studying the effect of bank lending techniques on firms’ financing constraints;
  • The share of branches in each firm’s geographic proximity that belong to banks which consider themselves relationship lenders as opposed to transaction based lenders;
  • A series of firm-level control variables, including size, ownership, age and dummy variables capturing whether the firm is an exporter and whether its financial statements are audited. We also create locality-level variables that control for other characteristics of the local banking landscape, such as ownership, capitalization, funding structure, and average distance to headquarters in the case of foreign banks.
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    Our empirical analysis points to the importance of relationship lending during a crisis. While there is no relation between the local dominance of relationship lenders and firms’ access to bank credit in 2005 (at the height of the credit boom in many of the sample countries), firms’ access to bank credit suffered significantly less in 2008/9 in localities dominated by relationship-based lenders. And the economic effect is also large: moving from a locality with 20 per cent relationship lenders to one with 80 per cent relationship lenders reduces the probability of being credit constrained in 2008/9 by 31 percentage points. We also find that this mitigating effect of relationship lending on firm’s financing constraints in 2008/09 is stronger for smaller, younger and more opaque firms with less collateral to pledge. There is no such difference in 2005. Finally, this credit constraint easing effect of relationship lenders is especially prominent in adverse macroeconomic environments, as gauged by regional or country-level GDP drops in 2008/9.

    What are the policy implications of our findings? The effect of a financial crisis on the real economy would likely be smaller if more firms could be induced to seek a long-term banking relationship. Supporting the collection of the necessary ‘hard’ information about SMEs through credit registries and thus incentivizing banks to invest more in generating ‘soft’ information themselves is another important policy message supported by our findings. Relatedly, our results also warn against an excessive short-term focus of banks, and their shareholders, on reducing costs by laying off loan officers and other frontline staff. In the medium term, and especially when an economic boom turns to bust, such cuts may negatively affect banks’ ability to continue to distinguish between firms with and without adequate growth prospects.

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    Beck, Thorsten, Hans Degryse, Ralph De Haas and Neeltje Van Horen (2014), “When Arm’s Length is Too Far: Relationship Banking over the Business Cycle.” EBRD Working Paper 169.
    Beck, Thorsten, Asli Demirgüc-Kunt, and Maria Soledad Martinez Peria (2011), “Banking Financing for SME’s: Evidence Across Countries and Bank Ownership Types”, mimeo, Journal of Financial Services Research 39, 35-54.
    Beck, Thorsten, Vasso Ioannidou, and Larisssa Schäfer (2012), “Foreigners vs. Natives: Bank Lending Technologies and Loan Pricing”, CentER Discussion Paper No. 55, Tilburg University.
    Stein, Peer, Tony Goland, Robert Schiff. 2010. Two Trillion and Counting. Assessing the Credit Gap for Micro, Small, and Medium-Size Enterprises in the Developing World. IFC and McKinsey


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