A Darker Side to Decentralized Banks: Market Power and Credit Rationing in SME Lending

Rodrigo  Canales; Ramana  Nanda

Article | Journal of Financial Economics | August 2012

A Darker Side to Decentralized Banks: Market Power and Credit Rationing in SME Lending

by Rodrigo Canales and Ramana Nanda

Abstract

We use loan-level data to study how the organizational structure of banks impacts small business lending. We find that decentralized banks-where branch managers have greater autonomy over lending decisions-give larger loans to small firms and those with "soft information." However, decentralized banks are also more responsive to their own competitive environment. They are more likely to expand credit when faced with competition but also cherry pick customers and restrict credit when they have market power. This "darker side" to decentralized banks in concentrated markets highlights that the level of local banking competition is key to determining which organizational structure provides better lending terms for small businesses.

Keywords: Geographic Location; Customers; Financing and Loans; Credit; Organizational Structure; Banks and Banking; Governance Compliance; Competitive Strategy;

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Canales, Rodrigo, and Ramana Nanda. "A Darker Side to Decentralized Banks: Market Power and Credit Rationing in SME Lending." Journal of Financial Economics 105, no. 2 (August 2012): 353–366.

Based in Portola Valley, California, Western Technology Investment (WTI) specialized in a hybrid form of debt and equity financing for early-stage companies. Like traditional venture capital and private equity firms, WTI raised funds from institutional investors and evaluated deals. However, instead of making initial investments in the form of equity, WTI focused primarily on lending money to start-ups, charging them interest and receiving warrants that could later be converted to stock in the case of a liquidity event. Most initial investments—usually in the range of $3–$5 million—were made in tandem with or following a company’s early rounds of venture capital equity financing. In addition, like more traditional venture capital investors, WTI hoped to participate in follow-on debt and equity investments in its successful portfolio companies.

Young, and particularly high-growth ventures often need to raise significant external finance, since their internal cash flow is usually insufficient to support the investments needed to grow. Although raising equity from venture capital or angel investors is the most well-known source of external finance for high-growth ventures, many entrepreneurs, particularly small business owners, rely on debt and other non-equity sources of capital to finance their ventures, either because equity capital is not available to them or because they want to avoid the ownership dilution and governance constraints associated with equity investments.

This note focuses on these non-equity sources of financing for entrepreneurs, paying particular attention to how the emergence of new technologies in risk assessment have expanded their availability for young firms.

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A Darker Side to Decentralized Banks: Market Power and Credit Rationing in SME Lending

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