Consolidation, Technology and the Changing Structure of Banks' Small Business Lending

Economic & Financial Review, Jan, 2001 by David P. Ely, Kenneth J. Robinson

The U.S. banking industry continues to consolidate, with large, complex banking organizations becoming more important. Traditionally, these institutions have not emphasized small business lending. On the other hand, technological advances, particularly credit scoring models, make it easier for banks to extend small business credit. To see what effects these influences might have generated on small business lending, David Ely and Kenneth Robinson explore the small business lending patterns at U.S. banks from 1994 through 1999. They find that larger banks are increasing their market share, most noticeably in the smallest segment of the small business loan market. The authors also present evidence that the size of the average small business loan has narrowed between small and large banks. These trends are consistent with increasing use of credit scoring models.

Long-standing restrictions on where banks could locate their operations began to erode more than twenty years ago and were mostly eliminated with the passage of interstate branching and banking legislation in 1994. As a result, the U.S. banking industry experienced substantial consolidation.(1) While this has likely contributed to the industry's robust performance of late, it could have important consequences for banks' small business lending. Large, complex banking organizations are traditionally not seen as significant sources of financing for small businesses.

On the other hand, the banking industry, like other segments of the economy, is an active participant in the information and communications revolution. Credit scoring models lower the costs of extending credit and improve access to small business financing, especially for larger banks. So, while consolidation could reduce small business lending, technological advances may increase the flow of small business credit.

In this article we summarize some of the ways consolidation and advances in technology may affect small business lending. We then examine the available data on small business loans over the period 1994 through 1999 to detect any changes in small business lending patterns and their possible consequences.

Although small business lending has increased since 1994, we find that the share of total lending devoted to small business loans has declined. However, the aggregate numbers conceal some important trends across organizations of different sizes. We find evidence that large banks are increasing their presence in the smallest segment of the small business loan market and that the average loan size has declined, especially at larger institutions. Larger banks also appear to have narrowed the gap relative to small banks in their focus on the smallest loans. These trends are consistent with the view that new information technology, most notably credit scoring, is changing the structure of small business lending.

WHY LOOK AT BANKS' SMALL BUSINESS LENDING?

Small business lending by banks has been the subject of extensive theoretical and empirical investigation. This reflects the value of small businesses to the U.S. economy and the potentially unique role of banks in small business lending. Small businesses (those with fewer than 500 workers) employ 53 percent of the private nonfarm workforce and are responsible for 51 percent of private gross domestic product. Small businesses are also responsible for a major portion of job creation. From 1990 through 1995, small businesses created more than three-fourths of all new jobs (U.S. Small Business Administration 1999).

Relationships

Banks fill an important niche in financing small businesses. Small firms are more likely to obtain financing from a commercial bank than from other sources, including depository and non-depository institutions (Cole and Wolken 1995).

Small business lending is often viewed as idiosyncratic and relationship-based. It depends on collecting and analyzing detailed, proprietary information because public information on small firms is often lacking. Many small business loans are treated in the same manner as consumer loans because the creditworthiness of the firm's owner--rather than the firm--is frequently a key factor in the lending decision. In contrast, ample public information is usually available about larger borrowers. The unique information requirements for small business loans may give smaller, more locally based banks an advantage in extending these types of loans (Berger and Udell 1996).

Lending relationships between banks and firms can reduce the monitoring and oversight costs associated with small business loans. Theoretical models of relationship lending can be found in Greenbaum, Kanatas, and Venezia (1989), Petersen and Rajan (1994, 1995), and Boot and Thakor (2000). These articles stress the presence of information asymmetries between borrowers and lenders and how banking relationships can overcome the problems associated with providing small business credit. For an overview of issues involved in studies of relationship banking, see Boot (2000).