Information-intensive and proprietary information

According to conventional wisdom, relationship lending is characterized by a continuous flow of information about the borrower to the lender. The information about borrower’s financial position and ability to meet future financial obligations includes usually the collection of the so-called “soft” data.¹⁰⁵⁵ By “soft” data is mean proprietary information about the firm¹⁰⁵⁶ (e.g.

business strategy, location, managerial capacities, etc.) as well as the firm owner (e.g. character and reliability of the firm’s owner).¹⁰⁵⁷ However, this is not say that banks base their lending decisions solely on this information. Rather, it implies that the closeness of relationship lending allows banks to acquire information, which is otherwise not accessible to the public. Hence, the notion of proprietary information. The information is enriched over time not only as a result of the length of the relation, but also due to the fact that often relationship lending is accompanied by a number of other services which banks provide additionally to the lender. More on this characteristic of relationship lending is to be found below.

Regarding the proprietary nature of the information, the borrower-specific information is usually available only to the intermediary, i.e. bank in this case, and to the customer providing this information.¹⁰⁵⁸ The proprietary information reaches the bank during the screening exercise, i.e.

before the loan is extended and during the negotiations of the bank with the potential borrower, as well as during the monitoring exercise, i.e. after the loan has been extended and the borrower has an obligation to repay the loan.¹⁰⁵⁹ The bank will use the proprietary information acquired when it needs to make decisions over time about future financing possibilities, adaptation of the contract terms and in designing monitoring and enforcement strategies to ensure the repayment of the loan by the borrower. The information is usually not passed on by the incumbent lender

1054 See also Elsas/Krahnen, Center for Financial Studies Working Papers, 2003, 1, p. 18 for a different categorisation of characteristics pertaining to relationship lending.

1055 Berger/Udell, World Bank Policy Research Working Papers Series, 2005, 1, p. F37.

1056 Hennrichs, Zeitschrift für Unternehmens- und Gesellschaftsrecht, 2006, 563, p. 378.

1057 Berger/Udell, The Economic Journal, 2002, F32–F53, p. F38.

1058 Boot, Journal of Financial Intermediation, 2000, 7, p. 10.

1059 Ramakrishnan/Thakor, Review of Economic Studies, 1984, 415, p. 423 ff; Diamond, Review of Economic Studies, 1984, 393, p. 393 ff; Winton, Journal of Financial Intermediation, 1995, 158, p. 165 ff; Boot, Journal of Financial Intermediation, 2000, 7, p. 10.

to other potential lenders. Even for the borrower is difficult to pass on to other potential lenders information that the incumbent bank has already produced, as the transfer is not costless.¹⁰⁶⁰ As a matter of fact, incumbent banks prefer to obtain a monopoly over the proprietary information of the borrower as this creates lock-in effects to the benefits of the lender in the form of higher interest rates.¹⁰⁶¹

1. Benefits from information-intensive lending relationships

The information-intensive characteristic of relationship lending can help narrow information asymmetries wedges existing between lenders and borrowers. It was stated above that borrower information to the lender remains proprietary and confidential in the sense that the bank, as the lender, will not pass this information not only to her own competitors, namely other lenders, but also not to the borrower’s competitors. This situation allows the borrower to reveal more hard as well as soft information to the lender than it would be willing to reveal if it borrowed directly from financial markets from fear of passing valuable firm information to own competitors.¹⁰⁶² Thus “two audiences” signalling problem is thus solved through relationship lending since borrower proprietary information will not spill over to an audience other than then relevant lender.¹⁰⁶³ From the lender’s perspective, obtaining borrower proprietary information helps create a monopoly over this information and in the same time provide her with an information advantage over competing lenders.¹⁰⁶⁴

Additionally, being often enduring and dominant lenders, especially of small and medium enterprises,¹⁰⁶⁵ provides banks with better incentives to invest in collecting and producing qualitative borrower information needed for monitoring. Chan/Greenbaum/Thakor address the issue of information reusability that lenders obtain in the course of lending.¹⁰⁶⁶ According to their view, a bank experiences stronger incentives to invest sufficient resources to obtain accurate and qualitative borrower-specific information when it can reuse¹⁰⁶⁷ the information for

1060 Degryse/van Cayseele, Journal of Financial Intermediation, 2000, 90, p. 93.

1061 See Sharpe, Journal of Finance, 1990, 1069, and Rajan, Journal of Finance, 1992, 1367.

1062 Bhattacharya/Chiesa, Journal of Financial Intermediation, 1995, 328, p. 330 ff.

1063 Boot, Journal of Financial Intermediation, 2000, 7, p. 13.

1064 This information advantage for lenders is further discussed below. (Section 4. Cross-selling)

1065 See e.g. Degryse/van Cayseele, Journal of Financial Intermediation, 2000, 90; Petersen/Rajan, Journal of Finance, 1994, 3, Berger/Udell, The Economic Journal, 2002, F32–F53, and Qian/Strahan, Journal of Finance, 2007, 2803, Journal of Finance, 2007, 2803, on the issue of the size of bank financing for SMEs and of the endurable bank lending relations.

1066 Chan/Greenbaum/Thakor, Journal of Banking and Finance, 1986, 243.

1067 Information reusability includes both information durability (i.e. it can continue to inform the bank through time regarding borrower’s financial status) and lender solvency. Chan/Greenbaum/Thakor,

future transactions as well, implying the existence of long-term relations with the borrower. The lender gains an information surplus, compared to its competitors, when it decides to screen borrowers more carefully and in the same time benefits from the selection of better quality assets or projects for investing through lending.¹⁰⁶⁸

2. Costs from information-intensive lending relationships

On the costs side, hold-up problems are said to be very common and empirically proven. Hold-up problems occur when the borrower is informationally captured because of the information monopoly generated by the lender in the course of lending.¹⁰⁶⁹ This information monopoly, which implies the existence of long-term and information-intensive lending relationships, allows banks to charge ex-post loan interest rates above lending costs, and thus higher than what it charged in the beginning of the lending relationship, cashing in in this way additional profits despite a reduction in the credit risk of the borrower.¹⁰⁷⁰ This is due to the increased bargaining power that the bank gains due to information monopoly, since the borrower cannot disseminate quickly and without costs the same amount of information that the incumbent lender possesses to other potential lenders. With regard to lending costs issues due to hold-up situations in a relationship lending, some authors point to the existence of competitive or non-competitive loan markets as factors that could mitigate or exacerbate a borrower’s situations. Thus, where loan markets are non-competitive and banks do not fear the losing of their customers to competitors, loan rates start low at the beginning of the lending relationship, increase ex-post when bank gains information monopoly and fall relatively slowly over the life of the lending relationship compared to the pace with which borrower credit risk falls. In contrast to that, in highly competitive loan markets, the loan rates charged ex-ante start high, but fall more quickly over the life of the lending relationship as the borrower credit risk falls.¹⁰⁷¹ However, increased competition might have the downside effect of decreasing relationship lending since bank rents from lending reduce.¹⁰⁷² In turn, a decrease of relationship lending could result in a deterioration

Journal of Banking and Finance, 1986, 243, p. 244.

1068 Chan/Greenbaum/Thakor, Journal of Banking and Finance, 1986, 243, p. 244.

1069 Boot, Journal of Financial Intermediation, 2000, 7, p. 17.

1070 See e.g. Rajan, Journal of Finance, 1992, 1367, and Berlin, Business Review of the Federal Reserve Bank of Philadelphia, 1996, 1, p. 3.

1071 Petersen/Rajan, Quarterly Journal of Economics, 1995, 407, p. 407 and Berlin, Business Review of the Federal Reserve Bank of Philadelphia, 1996, 1, p.4. However, competition in loan markets is a two edged sword. While it can reduce rents that banks extract from borrowers, it can also create difficulties for building long-term relationship and also reduce credit availability, especially for de novo or risky borrowers. See also Boot/Thakor, Journal of Finance, 2000, 679, p. 681.

1072 Petersen/Rajan, Quarterly Journal of Economics, 1995, 407, p. 439-42.

of borrower credit quality due to deterioration in bank screening and monitoring, although unambiguous evidence regarding this correlation is still incomplete.¹⁰⁷³