Do Bank Regulatory Practices Stifle Lending to Small Businesses?

In a newly released working paper entitled, Commercial Lending Concentration and Bank Expertise: Evidence from Borrower Financial Statements, Andrew Sutherland, Assistant Professor at MIT Sloan, and colleagues studied banks—including eight of the ten largest commercial and industrial lenders—and their lending practices to small firms.

Their study finds that banks generally require fewer audits from firms in their largest exposures, and do not have excessive rates of default in their loan portfolio.  This finding indicates that large exposures reveal a bank’s expertise and provide the bank with alternative information sources to make lending decisions. Moreover, the results suggest that regulatory pressure on banks to collect more hard information from the exposures in which they have the greatest expertise could stifle lending to small firms.

This finding is significant because, according to the Small Business Administration, firms with fewer than 500 employees accounted for 63% of net new jobs between 1992 and 2013. Moreover, a new report out from the Labor Department in November shows that job growth from new firms is slowing. Yet, despite their importance to the economy, small and new firms often face challenges accessing bank financing, and oftentimes these challenges relate to information asymmetries.

Sutherland and colleagues studied 728 banks hoping to discern whether the extensive documentation that banks required make a difference in terms of lending risk for banks. Could regulators unwittingly be discouraging banks from lending to firms operating in sectors they know well and are therefore equipped to lend to using their wealth of experience and soft information about an industry?

As part of that equation, the authors wanted to know whether exposure risk for banks that kept a large number of loans from the same type of company without substantial hard information collection was a threat, or whether such a concentrated number of loans in one industry might allow banks to become “expert” in one kind of business or sector and thereby actually increase their lending efficacy. Banks that have a lot of experience in one industry often rely on “soft” information, personal knowledge of the players and have expert substitute sources of information about an area of business that they get through repeated interactions with firms in that industry. This is what we call the “expertise” effect.

Author: Dylan Jones

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