Academic journal article Journal of Money, Credit & Banking

The Effect of Credit Scoring on Small-Business Lending

Academic journal article Journal of Money, Credit & Banking

The Effect of Credit Scoring on Small-Business Lending

Article excerpt

This paper examines the effect of credit scoring on small-business lending for a sample of large U.S. banking organizations. We find that credit scoring is associated with an 8.4 percent increase in the portfolio share of small-business loans, or $4 billion per institution. However, we fail to uncover any specific attributes of bank small-business credit-scoring programs that lead to this increased lending. Overall, we conclude that credit scoring lowers information costs between borrowers and lenders, thereby reducing the value of traditional, local bank lending relationships.

THE U.S. COMMERCIAL BANKING SECTOR has experienced tremendous consolidation this decade--due to the removal of geographic and product market entry barriers, advances in electronic technology, and financial innovation. Proponents of bank mergers and acquisitions often cite the consumer benefits derived from increased bank efficiency, competition, and geographic diversification. However, some policymakers have expressed concern that the emerging institutions may significantly reduce the availability of credit to small firms, which account for roughly half of U.S. private-sector employment and gross domestic product.(1) This conjecture is based primarily on the fact that bank call report data indicate that small banks hold a greater percentage of their assets in small-business loans than do large banks (Berger, Kashyap, and Scalise 1995).(2) The explanations offered for this disparity are grounded in the economics of information.

To date, theories concerning small-business credit markets have emphasized the existence of significant information asymmetries between borrowers and lenders (Nakamura 1993). It is also believed that such market imperfections can result in credit rationing by lenders, particularly when loans are unsecured (Stiglitz and Weiss 1981). To mitigate such problems, borrowers and lenders have historically used long-term relationships, or close and continuous interactions that generate useful information about the borrowers financial state (Frame 1995). Moreover, small businesses are thought to be dependent on local banks for such relationship-based borrowing. Empirical evidence confirms both the value of lending relationships (Petersen and Rajan 1994; Berger and Udell 1995; Cole 1998) as well as the use of local commercial banks for small-business credits (Elliehausen and Wolken 1990).

Studies concerning the effect of banking industry consolidation on small-business lending are generally motivated by (1) the stylized fact that small banks are relatively more active in this market; and (2) the theoretical emphasis on small-business credit market imperfections. Berger and Udell (1996) synthesize two theories positing that the provision of banking services to small businesses decreases with bank size and organizational complexity. The first is that the small-business lending is fundamentally different from large firm lending in that the former credits are more information intensive and relationship driven. The second, based on the work of Williamson (1967), emphasizes managerial diseconomies of scale with the provision of multiple activities in large, complex organizations.(3) The authors' empirical tests indicate that large banks tend to charge relatively lower loan rates to and less often require collateral of small-business borrowers. However, they find that large banks reduce their volume of relatively costly relationship loans via price or quantity rationing. Related work by Cole, Goldberg, and White (1998) indicates that large banks typically employ standard financial statement criteria in the loan decision process, while small banks focus more on their impression of borrower character.

While it appears that large and small banks approach lending to small businesses differently, the empirical evidence regarding the effect of bank merger and acquisition activity is mixed. Two early studies indicate that small-business borrowers may be adversely affected by consolidation (Keeton 1995 and Peek and Rosengren 1995). …

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