The Effect of Bank Size on Small-Business Lending Research by Raghuram Rajan
According to new 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. Peterson of Northwestern University, 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. "And
what we found was that bank size has a tremendous effect on
the nature of the relationship between a small firm and its
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
"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 information.
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 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
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,"
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.
Raghuram Rajan is Joseph L. Gidwitz Professor of Finance
at the University of Chicago Graduate School of Business.