Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

The Information Revolution and Small Business Lending: The Missing Evidence

Academic journal article Federal Reserve Bank of Atlanta, Working Paper Series

The Information Revolution and Small Business Lending: The Missing Evidence

Article excerpt

Working Paper 2010-7 March 2010

Abstract: This paper provides empirical confirmation for Petersen and Rajan's (2002) widely accepted conjecture that information technology was the primary driver of the observed increase in small business borrower-lender distances in the United States in recent years. Using a different data source for small business loans, we show that annual increases in borrower-lender distances were slow and steady prior to 1993 (the end point in Petersen and Rajan's data) but accelerated rapidly after that. Importantly, we are able to assign at least half of this acceleration to the adoption of credit scoring technologies by the lending banks. Our tests also reveal strong statistical associations between lending distances and borrower characteristics, lender characteristics, market conditions, regulatory constraints, moral hazard incentives, and principal-agent incentives.

JEL classification: G21, 033

Key words: borrower-lender distance, credit scoring, information technology, small business lending

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In one of the more widely cited papers in the recent finance literature, Petersen and Rajan (2002) document small, but systematic, increases in the geographic distances between small businesses and their bank lenders between 1973 and 1993. The authors primarily attribute this increase in borrower-lender distances to the greater use of information technology by lenders, empirically rejecting other potential causal factors such as banking industry consolidation and changes in the distribution of borrower locations over time. They conclude that better, cheaper, and faster access to information, which includes but is not limited to hard information about borrower creditworthiness, allows banks to lend to increasingly more distant firms without compromising their ability to successfully underwrite these credits, monitor the borrowers, and intervene when necessary. This conclusion has become a stylized fact in the financial economics literature and has motivated numerous studies of the impact of increasing distance on credit access, loan pricing, and loan and lender performance (see, e.g., Degryse and Ongena (2005); Agarwal and Hauswald (2006); Berger and DeYoung (2006); Brevoort and Hannan (2006); and DeYoung, Glennon, and Nigro (2008)).

Notably, Petersen and Rajan (2002) draw their key inference mainly from indirect evidence, which contains neither the application of information technology nor differences in lending production functions over time or across banks. Instead, the authors merely show that: (i) borrower-lender distance continued to increase over time after conditioning on other factors, and (ii) the ratio of bank employment-to-bank lending declined between 1973 and 1993, consistent with the substitution of hard information technology inputs for labor-related soft information inputs. Moreover, their database largely pre-dates the implementation of credit scoring models for small business lending (Akhavein, Frame, and White 2005), a strategically transcendent information technology that has transformed the retail banking production process.

In the absence of direct observable evidence, the inference drawn by Petersen and Rajan (2002) about the drivers of borrower-lender distances is an impressive accomplishment. Nonetheless, it is important to demonstrate whether, and to what degree, the inference is correct. We are not aware of any study that has either confirmed or refuted the Petersen and Rajan conjecture based on the observable application of information technology to small business lending. In this short paper, we establish a strong empirical link between small business credit scoring and borrower-lender distance for a sample of 31,880 Small Business Administration (SBA) loans originated between 1984 and 2001. During the first portion of our database, which overlaps the final ten years of the Peterson and Rajan data, we find small but steady annual increases in borrower-lender distances that are very similar to the pattern documented by those authors. …

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