More than 2,000 miles separate Silicon Valley Bank (SVB) in Santa Clara, California, from the Chicago-based Focal Communications Corporation. But that didn’t matter to Robert Taylor, ’90, president and CEO of Focal, a national communications provider. SVB was able to provide Focal with the favorable terms and the $5 million line of credit the company needed. “They were the biggest player. After they came and toured the facility, the rest of our communications were transacted via phone, fax, and e-mail, ” said Taylor.

Focal is not alone. Advances in computing and communication have reduced the human component in lending decisions. Using a data sample drawn from a 1993 National Survey of Small Business Finance, Raghuram G. Rajan, Joseph L. Gidwitz Professor of Finance, and Mitchell A. Petersen of Northwestern University’s J. L. Kellogg Graduate School of Management found that the geographical distance between small firms and their lenders grew dramatically from 1973 to 1993. A firm that began borrowing from its bank in 1993 was 34 percent farther away from the bank than an otherwise identical firm that began its lending relationship in 1983. The distance between lender and borrower also is growing more quickly over time––3.8 percent each year.

Not only do firms increasingly obtain loans from lenders located at a physical distance, they also communicate with lenders in more impersonal ways. The method of transacting business is moving away from personal contact to phone and mail. According to Rajan and Petersen, face-to-face personal communication between lenders and their customers has declined from 68 percent in the ’70s to 34 percent in the ’90s. And for firms that supplied financial records to answer Rajan and Petersen’s survey, the probability of communicating face-to-face further dropped when they had diffuse ownership structures and a national sales region.

Credit availability and competition in the credit market, even for weak borrowers, also has increased. In the past, only firms of the highest credit quality could obtain funding from a distant lender. But today, young small businesses can access credit, even in places where large banks have a monopoly position.

These changes are not a simple result of changes in small firm location, banking industry consolidation, or sample bias. Instead, they seem to be driven by advances in technology that have given lenders easy access to borrower data across great distances and at lower costs.Information Is PowerHistorically, small business lending has been very costly for lenders.

“That’s because of the paucity of information about small firms and the high costs in terms of the personnel required to build the relationships required to even get that information, ” said Rajan.

With the exception of some small and private firms in high-growth industries, analysts do not typically follow small businesses. And since small businesses do not raise capital in public markets, they are not required to disclose much information.

Clearly, lenders to the small businesses knew those firms, but these lenders were few in number and did not readily share information. As a result, much of the small businesses’ credit history tended to be “soft, ” relying on whether or not a company maintained adequate balances, for example, rather than on “hard” information that specified when and to whom payments had been made.

The recent expansion of infomediaries, such as credit bureaus and collection agencies, has made the availability of borrower credit records greater and timelier. Companies like Dun and Bradstreet (D&B) collect information on payment histories and defaults that previously was available to lenders only after a relationship had developed. D&B updates more than 11 million business records annually. “Over our sample period, the number of firms on which they had records grew 6.3 percent each year, or over two and a half times the real growth of the economy, ” said Rajan.

Hundreds of millions of pieces of data, ranging from trade experiences to financial statements, are integrated daily into a single file. The data entered is automatically checked and also subject to verification. D&B also alerts its customers to increases in a firm’s risk profile to prevent unnecessary losses. Specialized infomediaries such as D&B help prevent the duplication of information, amortize the cost of information collection over a larger number of customers, and distribute more information than could lenders in the past.

The increased availability of systematic and reliable information also has allowed loan officers to cut down on monitoring activities and has automated many tedious and costly processes. For example, with Automatic Loan Machines (ALMs), the process of taking a client’s information, checking records, evaluating the expected profitability of the loan, and then making the actual loan is completely automated. ALMs thus can offer on-the-spot loans to those with reasonable credit histories, regardless of whom they banked with in the past.

Furthermore, a process called credit scoring is increasingly used by large banks, such as Wells Fargo, to make lending decisions for small businesses. A loan applicant’s credit history and characteristics are summarized in a credit score, which forms the basis for approval or rejection of most applications. By using financial histories, credit reports, and scoring methods, banks can dramatically lower fixed costs and the time their loan officers spend on a given application.

State of the NationSmall businesses substantially benefit from a lowering of fixed costs in lending. If transaction costs drop sufficiently, the number of lenders willing to lend also may expand. This has the possibility of increasing the supply of capital available to small firms and reducing the cost of capital available to the extent that geographically larger markets become more competitive. Lower-quality credits may also benefit from better rates.

Additionally, regional market shocks could have a reduced impact on firms. When oil prices fell precipitously in 1986, a large number of firms in that industry, especially in Texas, were hit hard. Texan lenders tightened credit and small firms there couldn’t borrow. “If lenders can make loans at a distance, this kind of shock will be less likely in the future, ” said Rajan.

The importance of relationship lending for small firms has always been stressed. Relationship lending is based on the collection and processing of “soft” or intangible information. In the past, part of the incentive for a lender to develop a relationship with a borrower, even if initial loans were not cost effective, was the knowledge that the firm would be locked into a long-term relationship. The cost of the initial loan could be amortized over the longer relationship.

“Soft” information, however, often requires personal contact and is difficult to incorporate when credit decisions are made by computer models and credit reports. Therefore, small firms that are truly good credit risks––but look like bad risks on paper––will find capital more difficult to obtain.

“You have to look good on paper in order to get a loan, ” said Rajan, “when, in actuality, you may look better in person than on paper. ” As the relative costs of funding such firms rise, despite advances in information technology, lenders may simply ignore them, preferring to focus attention on more transparent firms. “So-called character loans that banks used to make in the past might be less likely, ” said Rajan.

Lenders may also be less likely to aid firms in distress. Banks had a greater incentive to help ailing firms when they knew that the relationship would continue. But now that firms have more borrowing options, banks lose that vested interest in a firm’s well-being. “There’s no special interest to help firms get out of trouble, ” said Rajan. “A lender may put in money, and if the firm sinks, the lender sinks, and if the firm gets better, there’s no claim on future business. ”