They Hire Economists

The Huffington Post recently reported on a pending piece of legislation working its way through congress. If it passes, small-business owners can zero in on banks most likely to make small-business loans. The anticipated bill could create between 500,000 and 700,000 new jobs.

The article highlights that most large regional, national and international banks favour multimillion-dollar loans to large corporations, not small-business loans. The reason being that the fee incomes on the large loans are much greater and it allows them to hire expert in industries they want to target. They employ economists and market researchers to help them avoid lending to businesses within riskier industries. This last statement reeks of asymmetric information and economies of scale in monitoring... so for those a little rusty of your “lemons” here is a quick refresher:

Often, borrowers are more aware of the hazards of financial contracts as they know more about the risks involved in a project for which they need finance. These informational asymmetries are the underlying cause of adverse selection first introduced by Akerlof in 1970, better known as the lemons problem. A lemons problem arises in debt markets as lenders have trouble figuring out whether borrower’s investment opportunities are attractive enough compared to the level of risk involved (“good risk” or “bad risk”)

These large banks can actually choose the growth industries that are more likely to be successful. The average cost of information decreases as the amount of intermediated resources is augmented, which normally occurs when the size of the entity grows. This is one of the mechanisms to reach scale economies on information, and can be achieved by the endogenous growth of the bank or by merge.

Large banks are still required to meet the goals of the Community Reinvestment Act, which states they must lend in the communities where they accept deposits. Providing small-business loans within their community is one way to do that. But, they prefer businesses with at least two years of profitability, excellent credit scores and owners with many years of related experience. The lenders also require solid collateral to be pledged.

Small community banks however, are able to make small business loans profitably. Taking advantage of the U.S. Small Business Administration's loan guarantee programs, they then sell the guaranteed portion into the secondary market. The upfront fees paid by borrowers, points received from buyers of the guaranteed paper, and servicing fees are sources of profit for them.

The bottom line here - small banks make small loans because they find them profitable. Large banks prefer larger loans and don't usually compete with small banks. That is why the pending small-business legislation is creating a fund to lend $30 billion to community banks with favourable terms. Whether or not the banks decide to participate, and to what extent they will make loans that they would not have otherwise made, remains to be seen.

Although the small-business bill can help you get financing, good credit scores and sound underwriting will still prevail.

Perhaps we really need more personal relationships in finance and banking. The lack of the latter and the current “one-size-fits-all” approach, might well have contributed to the huge credit losses of the recent past. Mortgages have not been given according to individual judgment in a case by case decision, but based on corporate guidelines. Perhaps it is time to bring a little more personal judgment into the banking system; doing so would help to alleviate the lemons problem.

Large banks like the ones we talk about in this article don’t do this for exactly the reasons stated above. This does however leave us with the potential for moral hazard problems… a landscaping contractor gets a loan ... and the branch manager suddenly gets a new landscaped yard? Or perhaps a bank makes a series of bad loans to people with poor credit histories because they were good kindergarten buddies, or were college roommates.

All of these problems can be overcome with government regulation. Is it any wonder that Canada, with its extensive regulation of the financial markets, was the only major country to survive the 2007-2009 credit crises? Is it any wonder that top UK bankers are leaving in droves?

See also this article in the Financial Times, Departing bank CEOs. *May need a subscription, but worth the read.

Terms:

Moral hazard: The tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behaviour.

Asymmetric information: The failure of two parties to a transaction to have the same relevant information. Examples are buyers who know less about product quality than sellers, and lenders who know less about likely default than borrowers.

Source: Economics by N.Gregory Mankiw and Mark P. Taylor