According to recent research, small banks have a comparative advantage in the arena of small-business lending because they are better able to collect and act on so-called "soft information" than large banks.
Due to changes in technology and the ongoing consolidation
of the commercial banking industry over the past thirty years,
the relationship between banks and borrowers has been growing
more distant and impersonal. These changes raise questions
not only about whether large banks will behave differently
than the smaller banks they are displacing, but about the
differences between large and small organizations as a whole.
One reason to believe that large organizations may behave
differently than small organizations is that they may have
different abilities to process hard and soft information.
Hard information, such as audited earnings, is easily captured
on paper. Soft information-intangible factors such as a potential
client's strength of character-is difficult to communicate.
The study "Does Function Follow Organizational Form?
Evidence From the Lending Practices of Large and Small Banks,"
by Raghuram Rajan, a professor at the University of Chicago
Graduate School of Business, Allen N. Berger and Nathan H.
Miller of the Board of Governors of the Federal Reserve System,
Mitchell A. Petersen of Northwestern University's Kellogg
School of Management, and Jeremy C. Stein of Harvard University,
examines whether large banks do as well as small banks in
small-business lending, an activity that relies heavily on
collecting soft information about borrowers.
"We wanted to see whether bank size has any effect on
the nature of small-business lending," says Rajan. "What
we found was that bank size has a tremendous effect on the
nature of the relationship between a small firm and its bank."
Hard and Soft Information
The reason for this effect is that the ease with which hard
and soft information can be used is often determined by the
size of the bank. Information about a small-business client
has to travel a much greater distance in a large banking conglomerate-from
the loan officer in a branch office to the decision-making
authority in a far away city-than in a small town bank. Only
hard information, in the form of easily verifiable data such
as income statements, balance sheets, and credit ratings,
can be credibly passed along such a bank hierarchy.
However, 43 percent of the firms in the study do not have
formal financial records, indicating that soft information
plays a significant role in determining whether these firms
are creditworthy. In many cases, these firms represent "main
street America," such as the local barber who needs financing
to set up an additional chair in his shop. Record keeping
at many of these establishments may be haphazard at best.
When loan officers have very little hard information to work
with, they have to estimate a client's earnings and judge
intangible elements such as trustworthiness to determine if
the potential client is a candidate for a "character
loan." These evaluations may be derived from subjective
qualities such as the strength of the client's handshake or
how well they make eye contact.
"The face-to-face interaction may help the loan officer
form a picture about whether the client can be trusted,"
says Rajan, "but when it comes time to write a report,
they're only writing down a sentence for their bosses saying
if this person is trustworthy or not."
At small banks, the decision-making authority is likely to
be in close proximity to the point of information collection,
which facilitates the communication of soft information. For
example, when a client requests a loan from a small bank,
the loan officer can easily bring the client to meet with
his manager face to face. The lending decision can then be
informed by the soft information resulting from this meeting.
However, if the loan officer works in a small town branch
office of a large bank headquartered thousands of miles away,
it is more difficult for that loan officer to communicate
soft information in a way that captures the richness of that
Serving Different Niches
To study the relationship between bank size and small-business
lending, Rajan and his coauthors used the Federal Reserve's
1993 National Survey of Small Business Finance, which examined
the financing practices of a wide sample of small firms. The
sample contains 1,131 for-profit firms, all of which have
fewer than 500 employees.
The authors looked at the firm's most recent bank loan and
matched each firm with the specific bank from which it borrowed.
Information about the banks was obtained from the Consolidated
Report of Condition and Income and the FDIC Summary of Deposits.
The authors' findings include the following: First, bigger
banks are more apt to lend to firms that are larger or that
have more detailed accounting records. Second, the physical
distance between a firm and the branch office that it deals
with increases with the size of the bank. This is consistent
with the notion that large banks rely less on the soft information
that is typically available through personal contact and observation.
Third, firms do business with large banks in more impersonal
ways, communicating more by mail and telephone than face-to-face
meetings. Fourth, bank-firm relationships tend to be both
longer-lived and more exclusive when the firm in question
borrows from a small bank. The reason for this last finding
appears to be that soft information produced by small banks
is more likely to be specific to a given banker and borrower,
and not easily transferable. Accumulated soft information
binds a borrower to its bank over time.
Given that small banks are better at building relationships
based on soft information, it can be expected that firms that
are bigger credit risks (including "difficult" borrowers,
such as firms that do not keep formal financial records) or
require more nurturing will seek loans from small banks, ensuring
that small banks occupy a niche market that will survive the
onslaught of bank mergers.
While the size of the bank that a firm borrows from matters,
the authors find that the size of the bank's holding company
does not. Lending decisions are typically made at the bank
level rather than higher up at the bank holding company level.
This pattern suggests that it is not simply the absolute size
of an organization that is important, but also the degree
of decentralization that can be achieved.
"Large organizations can undertake activities involving
soft information if they decentralize," says Rajan.
Implications for Other Industries
The study's findings regarding organizational size and the
use of information apply to other industries that emphasize
relationship building, such as consulting, law, research and
new product development, and law enforcement. In all these
industries, the organizational structure may play a crucial
role in determining how effectively the job is carried out.
The study also suggests that if multinational banks substantially
crowd out a developing country's domestic banks, the supply
of loans to small firms could be reduced. In these cases,
Rajan recommends that the headquarters of the foreign bank
should allow the local branch to have a reasonable amount
of decision-making authority over the loans.
In addition, Rajan and his coauthors caution that in many
countries, the standard practice of setting up large bureaucratic
organizations to provide subsidized credit to small businesses
may not be very effective.
"In a situation where soft information is generated,
bureaucracy does stand in the way, because bureaucracies are
incapable of processing the information that small-business
lending is based on," says Rajan.
Preliminary evidence by these researchers suggests that the
credible decentralization of decision making can offset the
negative effects of large organizations' size. Therefore,
it may be possible for a large organization to enjoy the best
of both worlds if it sets up internal structures that achieve
the right level of decentralization.