Academic journal article Journal of Money, Credit & Banking

Short-Term Loans and Long-Term Relationships: Relationship Lending in Early America

Academic journal article Journal of Money, Credit & Banking

Short-Term Loans and Long-Term Relationships: Relationship Lending in Early America

Article excerpt

Recent banking theory holds that durable firm-bank relationships are valuable to both parties. This paper uses the contract-specific loan records of a 19th-century U.S. bank and shows that firms with extended relationships received three principal benefits. First, firms with extended relationships had lower credit costs. Second, long-term customers provided fewer personal guarantees, which were an alternative to collateral. Third, long-term customers were more likely to have loan terms renegotiated during a credit crunch. These findings support theories that banks realize cost advantages through the use of proprietary information.


FINANCIAL INSTITUTIONS provide most external debt financing for small businesses. Approximately 50% of small business finance is owner-supplied equity, another 5% is owner-supplied debt, about 15% is trade credit, and 25% is borrowed from financial intermediaries, principally banks (Berger and Udell 1998). Thus, for most small businesses banks loom large. In fact, modern theories of financial intermediation view intermediaries as delegated monitors and are mostly theories about funding small, informationally opaque firms (Diamond, 1984, Ramakrishan and Thakor, 1984). To deal with information and incentive problems surrounding small business finance, intermediaries use collateral and personal guarantees and foster long-term relationships with borrowers.

Both practicing bankers and economic theorists argue that bank relationships are valuable. With repeated contracting, banks continuously gather information and update their evaluations of borrower creditworthiness. Berger and Udell (1998, p. 645) note that most small businesses have maintained a relationship with a bank for nine years and that a majority identify a commercial bank as their primary financial intermediary. Theory holds that small businesses that form relationships with a principal bank secure several advantages, including lower interest costs, greater credit availability, lower collateral demands, and protection against credit rationing in periods of firm distress. Yet, despite a general sentiment that firm-bank relationships are valuable, empirical evidence on the subject remains inconclusive.

This paper uses a unique contract-specific data set drawn from the surviving records of a 19th-century bank to analyze the value of firm-bank relationships. The Black River Bank of Watertown, New York, was a free bank operating under New York's Free Banking Act of 1838. This bank's records provide information on every loan made between 1845 and 1861 and data were collected for all loans in 1855 and 1857-1858, including the name and account number of the borrowing firm, the loan amount, the interest rate, the loan term, the number of consigners, the purpose of the loan, and whether the loan was renegotiated and renewed at maturity. Each borrower in 1855 and 1857-1858 was matched to the bank's loan records between 1845 and 1854 (1856) to determine the length and intensity of the relationship. The 1855 sample is then used to investigate how intensive bank-borrower relations influenced loan rates and third-party guarantees at the end of a decade-long economic expansion. The 1857-1858 sample is used to investigate how long-term relationships influenced a bank's willingness to renegotiate with borrowers during a financial crisis.

The data set offers several advantages over widely used survey data. First, as noted by Blackwell and Winters (1997) and Degryse and Van Cayseele (2000), focusing on a narrow set of lenders controls better for unobserved heterogeneity in bank lending standards and, therefore, borrower attributes. Second, most previous research measures the strength of firm-bank relationships using relationship duration, scope (the provision of complementary financial services), or exclusivity (whether the current bank is a main bank) instead of relationship intensity (the number of loans). …

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