The central role of the bank-company relationship in fair loan pricing

The credit crunch triggered by the global financial crisis of 2008-2009 prompted economists and researchers alike to attempt to pinpoint the key factors that influence access to credit for firms, in particular SMEs.

The issue of access to finance is a vital one for numerous countries where SMEs play a major role in national economies in terms of employment and income, and as drivers of innovation and growth. In fact, around 99% of all companies in the euro zone are SMEs, employing two-thirds of the work force and generating 60% of the value added. The economic contribution of these enterprises is particularly sizeable in countries in Southern European, especially Italy, Spain and Portugal.

To grow their businesses, SMEs rely for the most part on bank loans. For their part, in their lending activity, banks have traditionally focused on hard information which is standardized, easy to process, and codified in firms’ financial reports. What’s more, assessing the quality of borrowers and approving financing in general are processes based on statistical-quantitative techniques. But since relatively little information is available on SMEs, banks are usually reluctant to provide them with credit, and often either avoid financing these enterprises altogether, or apply higher interest rates on average. And in times of crisis, also due to data skewed by the economic contingency, bank shocks can dramatically constrict credit - with direct, immediate effects on SMEs.

In recent years, theoretical developments of the information economy have reignited interest in a process called ‘relationship lending.’ In fact, there are calls from many quarters to focus the attention of intermediaries on a relational approach to customers based on collecting and utilizing qualitative information (aka soft information) to shore up hard information in evaluating credit risk.

With these observations as our point of departure, we conducted a recent study to explore the impact on loan pricing of face-to-face contacts between banking representatives and companies.

We based our empirical analysis on data provided by an Italian banking group with branches located throughout the country, and we collected information on bank loans granted to a sample of 11,624 SMEs over a three-year period (2009-2011). Our aim was to investigate what types of contacts had the most impact in terms of access to credit and lower interest rates.

In the relationship between a bank and a potential borrower, face-to-face contact proves to be the most constructive way to reduce information asymmetry, offering the opportunity to collect soft information. But in evaluating the effectiveness of this contact, we also need to consider things like where the meeting takes place between the bank and the entrepreneur or his/her representative (at a teller’s window at the bank or at company headquarters); the physical distance between the bank and the company; and the how long the bank-company relationship has lasted.

What emerges from our study is that the value of the relationship lies in direct contact that takes place at the company; this allows the bank to apply a fairer interest rate on the loan. In fact, this type of meeting gives the bank the chance to gather invaluable soft information which is not directly observable if contact is indirect. From the office space to the production facilities to the quality of the equipment; from the level of company innovation to the level of leadership of the entrepreneur; from customer-centric focus and orientation to supplier relationship management, from business continuity and growth to employees’ values and their sense of belonging to the organization.

Our findings, in contrast other studies, show that the geographical distance between the bank that provides the loan and the company that receives it has very little economic impact on interest rates. Similarly, the duration of the relationship between the bank and the borrower company is not the primary consideration that determines access or cost of credit.

What does prove to be the decisive factor in understanding the behavior of banks and the pricing they apply to loans is contact with the company. Frequent contacts with lenders may help companies access the loan market and secure more advantageous conditions; likewise, having several relationships with different banks equates to lower interest rates on loans.

But we should point out that there is a dark side to relationship lending. When the bank-company relationship is exclusive, the bank might be tempted to take advantage of its ‘monopolistic’ position and charge higher interest rates. This so-called ‘hold-up’ behavior is particularly relevant if the company does not have viable alternatives in banking options or relationships, or if it faces high switching costs. To avoid this problem, companies can forge relationships with multiple banks. In fact, the picture that comes to light from our study indicates that the problem of hold-up does not depend on the duration of the bank-company relationship, as much as whether or not this relationship is exclusive. To sum up, then, the more exclusive the relationship, the higher the interest rates on loans.

• To fill the information gaps that prevent SMEs from regular access to bank credit, these companies should always opt for a relationship approach. This type of organizational model between banks and customers is one that satisfies the following conditions: more investments in gleaning customer-specific information, often proprietary in nature; more meticulous assessment of the profitability of these investments through multiple interactions with the same customer over time and/or across products.
• Frequent interactions between the bank and the company reduce the cost of debt, in particular when contacts take place at company headquarters. The optimum combination for the company is to establish a ‘wide’ relationship with the bank, taking full advantage of meetings, while expanding borrowing opportunities with other credit institutions at the same time.
• Lastly, public regulators could introduce incentives for banks and other lenders to encourage relationship lending, driving the financial system toward optimal behavior to support economic growth and stability.