Banks are the traditional lenders to small companies. They have specialized in assessing and monitoring borrowers, particularly companies too small to access the bond and equity markets directly.
In addition, because banks provide a variety of transaction services, such as checking accounts, payroll operations, and cash management services, they may have had informational advantages in monitoring and advising small businesses.
But recent changes in the industry will probably change the way banks serve such clients.
Firstly, the industry has undergone substantial consolidation, in part stimulated by the relaxation of barriers to interstate mergers and interstate branching. As banks grow and focus more on national and international markets, some lines-including small-business lending-may be less profitable than others more fully exploiting economies of size and scope.
Secondly, credit scoring models have altered the way some banks evaluate and monitor many loans. These models let banks offer credit on more favorable terms to borrowers with significant assets and good credit histories, because the risk of the loan can be assessed at a far lower cost than with traditional underwriting standards.
After a bank merger, roughly half of acquirers have increased and half have reduced the share of small business loans in their asset portfolios.
The pattern is sensitive to the size of the banks involved and the degree to which the buyer has chosen to specialize in such lending.
Small acquirers tend to increase small-business lending, large acquirers to reduce it.
Among large banks, however, those that have already chosen to focus on small-business lending are more likely to increase in that line.
In addition, big banks and smaller ones are increasingly specializing in different sizes of small business loans.
Among big banks, most increases in such lending have been in the smallest loans. This has probably occurred because loans under $100,000 are the most appropriate for applying credit-scoring models, which use many of the same screens as models used to identify good consumer loans.
In contrast, smaller banks are shifting emphasis more to loans of $100,000 to $1 million. Mergers of smaller banks may have contributed to this shift, serving to relax borrower-concentration constraints that had limited small banks' access to this sector.
We have found that banks with less than $100 million or more than $3 billion of assets each racked up asset growth of about 24% from June 1993 to June 1996. Yet the growth in their small-business lending-loans of $1 million or less-diverged sharply: 42% at small banks but only 3% at the largest banks.
Consistent with these findings, several recent studies have found that small-business lending is growing faster at small banks than large, and that large acquirers are less likely to expand in this sector.
Evidence suggests that organizational complexity does not account for these differences, though one study found that banks bought by out-of-state institutions tend to lend less of their funds to small businesses.
We believe an important factor in the willingness of banks involved in mergers to subsequently expand their small-business lending is how much the acquirer had already specialized in this area.
We and others have found that banks tend to at least partly offset the effect of mergers by subsequently bringing small-business loans closer to their pre-merger share of the portfolio.
This suggests that neither size nor any other single factor is likely to show an acquirer's propensity to remain active in this sector.
The reasons for acquiring a bank and for focusing on small-business lending are likely to be related to a variety of characteristics-of the acquirer and the target. But presumably a management that believes small- business lending can be profitable is more likely to continue to pursue the business aggressively after an acquisition.
The Benefits of Size
Because of prohibitions against an undue concentration of loans with a single borrower, small banks have no alternative-their loans must be small.
Banks that become substantially larger through acquisitions (as well as internal growth) have more potential business opportunities. They can extend much larger loans without concern that any one borrower could pose a significant risk to the financial health of the organization.
In addition, size enables a bank to exploit economies that may not be available to small banking organizations. Thus trading activities and credit card operations that are not feasible for smaller banks may provide profitable opportunities for large banks.
But though only large banks are likely to exploit high-volume, low- margin businesses, this need not imply that lending to small businesses will be unprofitable for them. Large banks may profitably engage in small- business lending in a variety of ways.
One is to focus on loan markets where size is an advantage.
Many such institutions have significant experience in making small home mortgage and credit card loans, then repackaging them to securitize and sell. They may provide such services more economically because they are likelier to use sophisticated risk and underwriting models; to monitor loans with innovative information technology; and to be expert in asset securitization.
New Worlds to Score
Some small-business loans also may be attractive candidates for credit scoring and securitization to the extent that they exhibit characteristics similar to other sorts for which banks have adapted credit-scoring models.
For example, small business loans to high-net-worth borrowers may provide an opportunity to use traditional credit-scoring models based mostly on the borrower's characteristics, rather than the firm's.
By treating such credits more like consumer loans, banks avoid the costs of obtaining a firm's balance-sheet and income statements and evaluating the underlying collateral. Such banks may be able to offer more favorable terms than those treating these credits as more traditional business loans.
All this suggests that larger banking organizations may be most willing to focus on loans small enough to be similar to consumer credits. Consequently, though most studies have defined small business loans as all with a value of $1 million or less, we have focused on three categories:
Loans with original amounts of $100,000 or less.
Loans from $100,000 through $250,000.
Loans from $250,000 through $1 million.
Our aim was to establish more clearly whether adapting credit-scoring models to the underwriting of small business loans may have become an important factor in large-bank lending to small businesses.
Another way large banks may profitably engage in small-business lending is by mimicking the information advantages that accrue to small institutions with close community ties.
These larger banks might still rely mostly on traditional underwriting standards, but process information more efficiently. Such banks could specialize in small business loans substantially more than the typical large bank, with the high margins more than compensating for the underwriting cost.
If so, large buyers that specialized in small-business lending would be more likely to continue to engage in it after mergers.
Easier Credit, Lower Costs
To sum up: The market for small-business lending has been influenced by consolidation and efficiency-enhancing information technologies.
The wave of bank mergers has occurred primarily among the smallest banks. These mergers involve acquirers that specialize in small-business lending, as their concentration in small business loans often exceeds that of their target.
By relaxing borrower concentration limits, these acquisitions enable small banks to make larger loans. As a consequence, the growth in small- business lending by small banks has been concentrated in the category of $100,000 to $1 million, even as these banks have reduced their portfolio concentrations in loans of $100,000 or less.
In contrast, some banks are competing more actively in loans of $100,000 or less-a result consistent with the adoption of credit-scoring models to originate such loans. Credit-scoring models reduce the cost of processing these loans; as such models are adopted more widely, borrowers with good credit ratings and collateral will probably be able to borrow at lower costs.
Consolidation and credit scoring are likely to keep shaping the small- business lending market. Consolidation will produce larger "small banks" capable of providing increased services to small business borrowers, and extending credit-scoring models to larger business loans should lower costs for more borrowers.