Universal Banking and the Future of Small Business Lending

Many argue that one category of bank clientele may have been lost in the rapidly changing structure of the U.S. banking industry small business borrowers. One reason for the concern over small business credit availability is the argument that small business has fallen victim to the increasing size and complexity of banking organizations. The proliferation of new bank product lines may have forced an internal competition for scarce capital and managerial attention in which the small business component of banking may have been losing ground. The recent wave of bank acquisitions may have had an equally powerful impact. Acquiring banks have often imposed their own idiosyncratic policies and procedures, stripping acquired banks of their autonomy and sometimes their management. More importantly, these critics argue, the process may have robbed acquired banks of their community identity and their appetite for loans to small local businesses. Arguably, these forces have had little downside cost for consumers who demand relatively generic financial services and who increasingly buy these services in national markets with substantial nonbank competition. They also would have little downside cost for large and middle-market businesses who demand the breadth of service that the more universal-like money center banks and the super-regional banks offer, and who benefit from access to alternative sources of funding such as the public securities market and the private placement market. However, for the small business customer the story is different. Small local companies may need an individual bank that has an understanding of the local business market and is staffed by personnel with local roots. These are said to be necessary conditions for the establishment and the continuation of a banking relationship and the tailoring of services to meet the idiosyncratic needs of the small firm. As banking organizations have become larger and more complex they may have reduced their supply of loans to small businesses. This problem may be exacerbated by the fact that the pool of independent community banks which could absorb this contraction in supply has been reduced by the acquisition of small banks by larger banking organizations. The authors present data from the June 1994 Call Reports that show that of the $63.17 billion of total bank credit available to businesses with bank credit needs of $100,000 or less, $41.13 billion of 65.1%, is provided by banks whose assets are $1 billion or less. Banks with more than $10 billion in assets provide only $7.82 billion or 12.4% of the total credit to these borrowers, despite the fact that these large banks provide almost half of the total domestic commercial bank credit. The authors show that as banks become larger they devote substantially less of their portfolio to small borrowers. The raw data appear to suggest that a sharp drop in small business credit is likely to occur as the banking industry consolidates and a greater share of the banking market is taken by banks with over $10 billion in assets. The authors cast the argument in more rigorous economic terms using two generally unrelated theories. The first is the proposition that the delivery of banking services to small businesses is a fundamentally different activity from the delivery of services to larger borrowers, with the small business market more information intensive and relationship-driven. The second theory emphasizes managerial diseconomies associated with the provision of multiple activities in large complex organizations. Putting these two theories together yields the implication that large, complex banking organizations may try to minimize the managerial diseconomies associated with servicing both large and small borrowers by reducing the supply of credit to some of the small borrowers. The purpose of the paper is to examine the proposition that the movement toward larger and more complex banking firms may come at the expense of the provision of some traditional banking services, particularly commercial lending to small businesses. The authors investigate empirically the association between commercial lending and both bank size and management/functional complexity using commercial loan pricing and bank call report data. They test whether large and complex banks have a reduced supply of credit to some or all types of small business borrowers relative to smaller, less complex banks. The analysis focuses on bank size and three different categories of organization complexity as explanatory variables in price and quantity regressions. The three complexity categories are: 1) measures of the layers of ownership or management, 2) measures of the numbers of different bank operating units, and 3) measures of the variety of different functions within the banking organization. Under the Small Borrower Hypothesis, larger and more organizationally complex banks have a reduced supply of credit to small business borrowers. These banks may reduce the supply of small business credit through either price or quantity rationing. Under the Null Hypothesis there is no association between the supply of credit to small business borrowers and either bank size or organizational complexity. The Relationship Borrower Hypothesis is similar to the first, but the latter distinguishes between two categories of small business borrowers one of which is affected by the size and complexity of the bank, and one of which is not. Under this hypothesis, some small business loans are relatively generic and involve essentially the same credit analysis techniques that are associated with larger, transaction-driven loans. The authors use the term 'ratio loans' for this category of business loans. In the other category of loans, the bank-borrower relationship is relatively important. The dynamic production of information over the course of the relationship becomes an important element in determining the interest rate, collateral requirements, and the quantity of credit supplied. The acquisition of these loans requires loan officers with an intimate knowledge of the local community. The authors term these loans 'relationship loans.' Under this hypothesis, as banks become larger and more complex the amount of credit available to relationship borrowers is reduced but the supply of ratio loans is unaffected. The evidence generally supports the Relationship Borrower Hypothesis, and may provide somewhat less support for the Small Borrower Hypothesis. Larger banks tend to charge lower loan rates to and less often require collateral of small business borrowers. The estimated price effects are substantial large banks are predicted to charge about 100 basis points less on loans issues to small businesses and require collateral abut 25% less of the time than do small banks. Larger banks also tend to issue many fewer loans to these borrowers. With respect to organization complexity, the results are less strong overall. A bank that is organizationally complex is predicted to impose a collateral requirement less frequently for small borrowers, but charge a higher interest rate given its collateral requirements than a bank that is not complex in any of the dimensions. The price results also are somewhat mixed, with prices generally increasing in some of them and deceasing in some of them. The quantity regressions suggest that banks that are more organizationally complex overall generally provide less credit to small borrowers, although this result does not hold for all of the individual complexity variables. The null hypothesis is rejected -- complex banks clearly treat small borrowers differently from non-complex banks. The findings do not necessarily suggest that the trend toward consolidation in the U.S. banking industry will result in a great contraction of credit to the small business segment because other institutions may pick up much of the slack left by consolidation. To the extent that loans to small business are currently positive net present value investments, they will likely remain so, although perhaps primarily so only for institutions other than large, complex banking organizations. The findings suggest that an important role may remain for community banks who have an advantage over large banks in extending loans to small businesses. Their local roots and knowledge of the local community and the entrepreneurs who run local businesses may be critical in providing the type of relationship-driven loans that many small business need.