Are you undecided whether to approach a big bank or a small bank for a business loan? If YES, here are 3 key reasons you should go to a small bank for a loan.
To start a business or fund a project, an entrepreneur can borrow from a number of banks. There are two types of these banks; small and large banks, with at least two banks of each type. This ensures competition not only between different but also the same types of banks. Small and large banks observe entrepreneurs’ productivity, but otherwise they differ from each other in many ways.
Pros and Cons of Dealing With Smaller Banks
In recent years, small banks in the united states have been susceptible to growing competition from large banks when it comes to small business lending. This growing competition was engineered by low cost technologies and improvement in information sharing, which have eroded informational advantages of small banks.
Since small banks are still significant lenders to small businesses, an important question arises as to how competition from large banks will affect the type of lending provided by small banks. The advantage of small banks is their proximity to entrepreneurs, which allows them to better evaluate the risk of projects undertaken by these entrepreneurs.
The disadvantage of small banks is their higher cost of lending (e.g., screening and monitoring costs). Large banks have a lower cost of lending, but cannot observe the risks taken by their borrowers.
But even with the cheaper loans offered by larger banks, small banks attract entrepreneurs of intermediate productivity in equilibrium. These entrepreneurs borrow from small banks because small banks evaluate their projects and provide tailored loan rates.
However, high-productivity and low-productivity entrepreneurs choose the low-cost banks. High-productivity entrepreneurs understand that small banks ability to monitor projects doesn’t add much to the value of their projects, so they choose cheaper loans from the larger banks.
Low productivity entrepreneurs prefer to undertake riskier projects using funds from any banks that will lend to them, so they choose cheaper loans from the large banks as well. With this, the growing competition from large banks has propelled small banks to concentrate in lending to intermediate-productivity entrepreneurs and reduce their share of lending to high and low-productivity entrepreneurs.
Nonetheless, there is a big argument that small banks tend to have a comparative advantage over large banks in lending to informationally opaque SMEs by using relationship lending technologies which are based in soft information. How possible is this?
3 Key Reasons Why an Entrepreneur Should Approach Smaller Banks for Business Loans
Over the years, experts have investigated the performance of large and small banks in relation to business lending. A number of performance measures have been used to compare the difference in efficiency between the two banks. Thus implicitly or explicitly, below are three core reasons why small banks are better than large banks in terms of offering business loans.
- Information Advantage
Over the years it’s been argued that small banks are more informationally efficient than their larger counterparts because they are better able to acquire and synthesize soft information from their small business customers. Note that this is possible because the nature of small banking business allows small banks to establish a longer and more personal relationship with their customers over time.
From the constant checking of the account history of their local customers, small banks are able to monitor their cash flows and sales performance over time and then leverage this information in the lending process. Large banks are unable to acquire detailed information like this since they most likely deal with bigger businesses that often have multiple business divisions and keep several banking relationships.
- Scale of Operations
Since small banks do not have too many layers in the organizational hierarchy like large banks, it is quite easy for loan officers to transmit confidential financial information about a customer’s loan portfolio and the surrounding business circumstances to the banks management.
While larger banks, on the other hand, with too many layers of managerial control and extensive branch network are disadvantaged in small business lending because it is difficult for top managers to review all loan applications, especially over a wide geographical range. Thereby, they tend to centralize all lending decisions in order to avoid agency problems.
Also note that loan officers at large banks are given less autonomy than their small bank counterparts and are often mandated to follow strict lending guidelines. As a result, large banks might have strong disincentives to establish business relationships in the local society and this means less acquisition of borrower information.
Since small banks have cost advantage in information gathering, they are without doubt more efficient than larger banks in delegated monitoring and enforcement of small business loans contracts.
- Relationship Development
The essence of relationship banking is to build proprietary information by developing relationships with customers, which will in turn be used to form lending decisions. Relationship lending is more suited to small businesses than larger ones since small firms are informationally opaque.
Note that relationship banking improves information exchange between the lender and the borrower, thus overcoming the problem of information asymmetry. Howbeit, relationships improve information quality and reduces the probability of discouragement of good borrowers in a competitive market.
Relationship banking also offers flexibility and discretion in financial services contracting. This flexibility can also enhance investment efficiency. Relationship banking also allows for better control of potential conflicts of interest and reduces agency cost.
Although it is clear that large banks have the comparative advantage over small banks in the use of hard information, i.e. financial statements and other quantitative techniques in small business lending.
However, small banks have the comparative advantage in the area of generating and processing soft information as well as in developing value-enhancing customer relationships. Nonetheless, more research is recommended for any entrepreneur seeking business loans in the United States.