- 24 Jun 2008
- Working Paper
Bank Structure and the Terms of Lending to Small Businesses
Executive Summary — Access to "soft information" and the greater sensitivity of decentralized banks to the local institutional environment can have both positive and negative consequences for small firms. Hence there may be a dark side to decentralized bank lending in certain instances. This paper argues that the same ability of decentralized banks to act on soft information also makes them more responsive to the local environment when setting terms of their loans. While this can be beneficial for small businesses in competitive markets, it also implies that the organizational structure of decentralized banks might allow them to better exploit their market power in concentrated banking markets by restricting credit or charging higher interest rates from small businesses. Key concepts include:
- According to the findings, small firms and those with greater "soft information" were more likely to get larger loans from decentralized banks, particularly in environments where the legal enforcements of financial contracts were relatively weak.
- On the other hand, decentralized banks were also more likely than centralized banks to cherry-pick the best firms, give smaller loans, and charge higher interest rates in concentrated banking markets.
- The relative benefit of decentralized bank structures for small business lending may therefore depend critically on the institutional and competitive environment in which banks are located.
- Public policy should consider promoting competition between decentralized banks in order to truly achieve the benefits associated with credit access for small businesses or those with more "soft information."
Using loan-level data from Mexico, we study the relationship between the organizational structure of banks and the terms of lending to small businesses. We find that banks with decentralized lending structures-where branch managers have autonomy over the terms of lending-give larger loans to small firms and those with more "soft information"-particularly in states with weak legal enforcement of financial contracts. However, decentralized banks are also more responsive to the competitive environment when setting loan terms. They are more likely to restrict credit and to charge higher interests rates when they have market power, more so to smaller firms that have fewer outside options for external finance. These findings highlight a 'darker side' to decentralized banks and suggest that the relative benefit of a decentralized bank structure for small business lending depends critically on the nature of the competitive environment in which banks are located.