When Arms Length Is Too Far - Relationship Banking over the Business Cycle
Does relationship banking, where banks and their clients interact closely on lending decisions, offer the best method for insulating SMEs from a financial downturn?
In the wake of the global financial crisis the attention of policy makers focused on lending practices to small and medium-sized enterprises (SMEs), as these firms' borrowing had been among the most affected.
It was considered how best to protect SMEs from business cycle downturns, and the relative performance of bank business models that rely on relationship lending versus those that rely on transaction lending has become a key focus of interest.
Banks have been urged to go back to basics and to put more emphasis on relationship lending. This is where banks interact with their clients in order to obtain and respond to proprietary borrower information. It has traditionally been seen as a more appropriate tool for banks to reach out to SMEs compared to transaction lending (otherwise known as 'arm's-length lending).
For this research the impact of relationship lending on firms' access to finance in both a credit boom and bust were studied. The research utilised both bank and firm survey data from a large sample of countries. It examines the impact of relationship lending on firm's credit constraints at different points of the business cycle. It finds evidence that the importance of lending techniques for firms' financing constraints varies importantly across the business cycle, and that relationship lending specifically seems to be a more adequate lending technique during a downturn.
These findings have significant implications for policy makers. While recent studies have pointed to the benefits of a diversity of lending techniques, this research suggests that relationship lending could have a more prominent role to play during economic downturns. Lending to SMEs during such periods tends to be particularly affected, potentially delaying a recovery. The effects of a financial crisis would likely be smaller therefore if more firms could be induced to seek a long-term banking relationship.
The research working paper is available for download at the link below.