Are Bank Loans Still Special?

By Becketti, Sean; Morris, Charles | Economic Review - Federal Reserve Bank of Kansas City, Third Quarter 1992 | Go to article overview

Are Bank Loans Still Special?


Becketti, Sean, Morris, Charles, Economic Review - Federal Reserve Bank of Kansas City


During the recent recession, many businesses had problems getting new bank loans. Increases in problem loans, the need to raise capital, and stricter regulatory oversight combined to discourage banks from extending new credit, particularly to businesses. The weakness in bank lending to businesses, some believe, contributed importantly to the downturn in economic activity.

Those who blame the recession on weak bank lending believe that banks are the only source of credit for most business firms--that is, bank loans are special. In recent years, however, rapid growth of nonbank sources of business credit has led others to believe that bank loans have become less special. Finance companies now vie with banks to meet firms' financing needs, and commercial paper allows many firms to raise funds directly from credit markets rather than through banks. If these other sources of business credit are in fact good substitutes for bank loans, then a slowdown in bank lending is not as damaging to the economy.

This article examines evidence on whether other sources of business credit have recently become better substitutes for bank loans--that is, whether bank loans are less special than they used to be. The results of the examination suggest that bank loans are becoming less special. The first section of the article explains why bank loans have traditionally been special. The second section examines the rise of substitutes for bank loans. The third section presents evidence that nonbank sources of credit are becoming better substitutes for bank loans.

WHY HAVE BANK LOANS BEEN SPECIAL?

Business firms get credit either by issuing debt securities to investors or by taking out a loan from a financial intermediary. Loans have been the source of credit for most firms because financial intermediaries have cost advantages over individual investors in gathering information about borrowers. And banks have been the source of most loans because they have had other cost advantages over other financial intermediaries. Thus, bank loans have been the source of credit for most firms--that is, bank loans have been special.

Before making a loan, all lenders--whether investors in bonds, nonbank lenders, or banks--need information about borrowers due to the risk that the loan might not be repaid. To determine the creditworthiness of a borrower, a lender gets information about the borrower's character, financial strength, business prospects, management skill, and any other factors that might affect the likelihood of repayment. After collecting the information, the lender then decides whether the loan is worth the risk.

After a loan is made, lenders must monitor the borrower because the likelihood of repayment can fall. For example, the borrower's business prospects or financial condition may deteriorate, or the borrower may engage in activities that decrease the likelihood of repayment. By monitoring the borrower, the lender can recognize these events and can call the loan or refuse to renew it when it matures.

Most businesses obtain funds by taking out a loan from a financial intermediary rather than by issuing bonds to a number of investors. In general, businesses want to borrow more than an individual investor is willing to lend. As a result, a business must borrow from a number of investors either directly or indirectly through a single financial intermediary that pools their funds.(1) If investors provide the funds directly, each investor has to gather information about and monitor the borrower. In this case, each investor bears the full cost of information gathering and monitoring.(2) But if a financial intermediary provides the funds, the information gathering and monitoring are done only once, and each investor bears only a small fraction of the cost.(3) Thus, most businesses take out loans because it is cheaper to get loans from financial intermediaries than to sell bonds to individual investors. …

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Are Bank Loans Still Special?
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