Theory to Practice

Face-to-face contact lowers the cost of bank loans

We recently demonstrated that direct interaction between banks and firms may affect loan pricing, leading to cost savings for firms. 

The context

The 2008-2009 financial crisis prompted economists and regulators to scrutinize the factors that impact firms’ access to financial resources. Small and medium-sized enterprises in particular depend on bank loans, but shocks to the banking system can trigger a credit crunch. In fact, during the crisis, interest rate spreads on loans to SMEs increased to partially offset expansionary monetary policy. This was the setting for our research, in which we focus on factors that allow SMEs to access credit at reasonable prices. We pay special attention to the informational privilege that banks can gain through contact with their borrowers.
Thanks to “relationship lending,” which is grounded in the duration, exclusivity, and intensity of the bank-firm relationship, businesses may be able to borrow at lower interest rates. To delve deeper into this idea, our study integrates extant literature using more detailed metrics to measure the strength of borrower-lender relationships while factoring in a wide range of variables. These include the number of face-to-face (f2f) contacts between the bank and the firm during a given year and where these contacts occur.
We opted to focus on data from Italy for several reasons. To name two, first companies in this country are highly dependent on bank loans, which makes them vulnerable to any distortion in the credit market. Second, multiple lending is a long-standing tradition among Italian firms, which makes them particularly interesting to study in the context of relationship lending.
An additional aim of our research is to shed light on the hold-up problem, which is seen as one of the main negative effects of a close bank-firm relationship. Hold-up refers to the bank, thanks to its bargaining power, imposing unfavorable loan conditions after the borrower has already made specific investments to finalize the transaction.

The study

We examined credit data from a large European bank to find out how the frequency of customer contacts affects lending relationships. Specifically, we collected information on the duration and intensity of the relationship in question, the geographical distance between the bank and the borrower, and other variables that impact credit approval. We ran our empirical analysis using data from the Corporate Banking division of an Italian banking group that has granted loans to firms located in all 110 Italian provinces representing 178 industrial sub-sectors. The sample we compiled counts 11,624 SMEs that contracted loans from 2009 to 2011. For each firm, we analyzed loan amounts, risk, the duration of the relationship, credit concentration, banking products that the borrower purchased and other pertinent variables. With these data in hand, we developed an ad hoc theoretical model to interpret our findings.

Conclusions and takeaways

The aim of our study is to assess the effect of f2f contact in relation to the cost of credit. Our hypothesis is that banks lower their interest rates when borrower-lender information asymmetry is reduced or eliminated altogether. We considered physical contact as the most valuable kind of bank-firm interaction because this is when the bank can obtain relevant input to minimize information asymmetry. Our findings show that more frequent interaction between the company and the bank can mean lower loan pricing, especially if in-person encounters take place at company headquarters. In fact, during such meetings, the bank can glean vital information on the firm’s business and processes.
Our study also shows that firms which purchase several products from the same bank get better loan conditions. In contrast, the duration of the relationship and the physical distance between the bank and the firm do not appear to have any effect on loan pricing. What’s more, our work reveals that the more banks a firm deals with, the lower the interest rate it pays. This may be due to the bargaining power that a lender which holding something of a monopoly would have.
To sum up, our results reveal that face-to-face contact is a powerful tool for reducing information asymmetry between banks and firms, allowing borrowers to obtain better loan conditions. A possible consequence of this may be fairer loan pricing and higher quality loan portfolios, which in turn would drive economic growth and shore up the stability of the financial system. These takeaways can prove useful not only for banks and firms but for regulators and policymakers as well, who could introduce incentives to optimize the financial system and support economic growth.