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Relationship Lending: That Ship Has Not Sailed for Community Banks

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How do small relationship-based C&I loans enhance the value of community banks compared to larger C&I and transactional CRE loans across different economic conditions?

Image courtesy of interviewee. December 1, 2024

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This video discusses the challenges banks face in identifying suitable borrowers and accurately pricing loans, emphasizing the problem of information asymmetry between borrowers and lenders. Large, publicly traded companies are easy to assess due to their public disclosures, while small, opaque businesses present more difficulties for banks. Community banks overcome these challenges by fostering relationships with their clients, thus gathering "soft information" that can create a monopoly on borrower data. This video approach can lead to "hold-up costs," making it hard for borrowers to switch banks.

The discussion also analyzes the profitability of relationship-based lending, contrasting it with transaction-based lending. While community banks may charge higher interest rates based on their acquired information, the associated costs of monitoring borrowers can be significant. The author posits that if relationship lending is beneficial, it should manifest in a market premium associated with small business loans.

Empirical research demonstrates that small business loans do add market value to banks, showing a considerable premium compared to larger commercial loans, which are more transactional. This video value persists during economic downturns, highlighting the importance of community banks in tough economic times. The study finds no significant competition from FinTech lending, which usually lacks relationship-building elements.

This video concludes by noting that small community banks continue to play a vital role in supporting small businesses through relationship lending. There are concerns regarding the challenges these banks face from regulatory pressures and technology adoption costs, as well as the trend of mergers and acquisitions that may affect their operational strategies. Future research is suggested to investigate the after-effects of bank consolidations on relationship lending.

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Here are five key points from the video:

1. **Asymmetry of Information**: The video highlights the challenge banks face in identifying good borrowers, particularly emphasizing the concept of "asymmetry of information" between borrowers and lenders. Large, publicly traded companies have transparent and accessible information, while small, non-public businesses lack such transparency, making it harder for banks to assess their creditworthiness.

2. **Relationship-Based Banking**: Community banks develop relationships with small borrowers to gather "soft information" about their creditworthiness. This relationship-based model allows community banks to better understand their customers’ businesses, leading to more informed lending decisions, while also creating a competitive advantage that can translate into higher interest rates due to the hold-up costs associated with such relationships.

3. **Market Premiums**: The study aims to estimate whether relationship-based lending is associated with market premiums. If banks can successfully derive additional revenue from lending to small businesses through their established relationships, this should manifest as market premiums in terms of higher acquisition prices for banks engaged in this type of lending.

4. **Value of Relationship Lending**: The evidence suggests that small business loans provide value not only during normal economic conditions but also in challenging times (such as during the 2007-2009 financial crisis). The established relationships allow community banks to better manage risk and increase loan demand during economic downturns.

5. **Impact of FinTech**: Contrary to concerns that FinTech lending might undermine community banks, the findings indicate that FinTech operates on a transaction-based model and does not compete directly with the relationship-based model of community banks. This suggests that community banks retain their vital role in small business lending by leveraging their ability to evaluate and monitor borrowers through personal relationships rather than solely relying on observable characteristics.

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Here are some key quotes and phrases extracted from the video that encapsulate the main points:

1. **Asymmetry of Information**: "So it is called asymmetry of information between a borrower and a lender."

2. **Difficulty with Small Borrowers**: "When we are talking about small borrowers that are non-transparent, mostly non-publicly traded businesses, it's very difficult to figure out the riskiness and projected cash flows."

3. **Role of Community Banks**: "Banks need to develop relationships, and that's exactly what community banks do. They established and they cultivate the relationship-based business model."

4. **Soft Information**: "Over time, when they acquire this so-called soft information, they create a monopoly on that information and subject their customers to so-called hold-up costs."

5. **Hold-Up Costs**: "Hold-up cost means that the customer wants it locked in and the customer to switch to another bank later on."

6. **Relationship-Based Lending**: "We actually try to estimate whether relationship-based lending is associated with market premium."

7. **Benefits to Firms**: "Most of the literature focused on how firms benefit from bank relationships."

8. **Stigma of Losing Relationships**: "If the company stops bank relationship, if the bank drops the firm, then it’s a stigma."

9. **Mixed Evidence on Interest Rates**: "Some studies find that interest rates go up over time, which allows the banks to utilize their monopoly power...some studies find that interest rates actually go down."

10. **Revenue vs. Cost**: "It’s basically revenue minus cost."

11. **Market Premium**: "If revenue exceeds cost, then it should actually show up in the market risk premium."

12. **Community Banks' Resilience**: "The value-enhancing effect of small business loans is present not only during normal economic conditions, but also during tough times."

13. **FinTech Lending**: "We find no evidence that the development of the FinTech industry somehow influenced that market premium."

14. **Importance of Community Banks**: "Community banks are important. They are vital to small businesses, and their business model is working."

15. **Future Research Directions**: "We want to go further and see, do acquirers actually maintain relationship lending?"

These quotes highlight the challenges banks face with lending, the importance of relationships in community banking, and the potential value derived from those relationships in terms of revenue and market premiums.

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One of the biggest challenges in banking is identifying

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good borrowers and pricing loans properly.

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And the less the bank knows about the borrower,

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the harder it is for a bank to make a proper credit decision

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and price it correctly.

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So it is called assymetry of information

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between a borrower and a lender.

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So when the borrower is a large publicly traded company,

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the information is there, there are disclosure requirements,

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there are analysts who follow the firm.

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Uh, there is media coverage, so it's easy for a bank

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to figure out the correct risk associated with that company

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and, and price the loan correctly.

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But when we are talking about small borrowers

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that are non-transparent, opec,

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mostly non-publicly traded businesses, it's very difficult

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to to figure out the, the riskiness and,

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and projected cash flows.

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So now what happens is with, with those borrowers,

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banks need to develop relationships,

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and that's exactly what community banks do.

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They established and they cultivate the,

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the relationship with their customers,

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and they strive on

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that relationship based, business model.

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So they know their customers, they take genuine

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interest in their business plans.

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They come to visit, they come to the sites

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before they make loan decisions.

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So over time, when they acquire this,

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so-called soft information,

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they create a monopoly on that information

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and subject their customers to, so-called hold up cost.

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So hold up cost means that the customer wants it locked in

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with a particular bank, it's very difficult for

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that customer to switch to another bank later on.

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So, you know, utilizing that hold up,

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problem

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and basically the monopoly power on information,

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the banks eventually are able to extract extra revenue

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and extra earnings by lending to those customers at a rate

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that might be higher than the competitive interest rate.

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On the other hand, it is expensive process

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to acquire that information.

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So even though the banks might get extra returns,

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they also need to pay extra cost associated

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with acquiring that information.

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So the question becomes, is it a valuable thing to do?

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Is it valuable thing to do

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to actually establish those relationships with customers

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and, you know, operate

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with relationship based business model?

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Well, in the end of the day,

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it's basically the extra revenue versus extra cost.

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And ultimately what is going to happen is

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if that model is actually, you know, valuable,

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then we should see it, in market risk premium,

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excuse me, in in market premium associated

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with small business lending.

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So what we do, we actually, you know, try

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to estimate whether relationship based lending is associated

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With market premium, right?

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In other words, if markets are willing to pay extra

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for every dollar of small business loans,

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and that way we address this question

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of whether relationship planning is actually valuable.

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The literature mainly focused on the values to the firms,

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because if you think about it,

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there are, there are two sites.

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There is a bank, and then there is a borrower or the firm.

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And most of the literature focused on

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how firms benefit from bank relationships.

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And there are studies that demonstrated that, due to

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that relationship based, model, the firms get,

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additional access to credit.

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So it's increased credit availability,

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more favorable contract terms.

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And even for larger firms, the bank relationships,

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are associated with signals, positive signals to the market.

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For example, when large company obtains a big loan

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for a bank, the stock market views it as a positive signal,

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and the, the stock price of a company goes up

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because market believes that the bank did their job.

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They looked at that firm, they figure out it's a good risk.

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So markets view it as a positive signal.

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On the other hand, if the company, you know,

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stops bank relationship, if the bank drops the firm,

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then it's a, it's a stigma.

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You know, it's a considered, a negative signal.

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So all in all, it's pretty conclusive evidence in the

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literature that firms do benefit from bank relationships.

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However, there is a lot less in the literature on

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how banks benefit from it.

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And one of the mechanisms, is through

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this holdup, problem.

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Uh, and, and as a result, the, the banks are supposed

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to raise interest rates as relationships continue.

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So most of the studies, on value to banks

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of relationship planning focus on interest rate behavior.

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So they look at how interest rates change over the course

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of, of, of relationships,

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with a particular firm, and they find mixed evidence.

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Some studies do find that interest rates go up over time,

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which allows the, the banks actually to,

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to utilize their monopoly power.

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Some studies find that interest rates don't change,

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and some studies find that interest rates actually go down.

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The problem is that these findings are very hard

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to interpret because it's,

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it's not only about interest rates,

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it's also about the actual cost

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of monitoring those customers.

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And over time, as the relationship progresses, the cost

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of monitoring may actually go down.

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And as a result, the banks don't necessarily

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have to raise interest rates.

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They may keep them constant

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or even allow the customers to get a little bit

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of a discount because the cost of monitoring is going down.

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So it's basically revenue minus cost.

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And because the costs are unobservable, it's very difficult

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to make any conclusion about the net effect

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of relationship lending on, on, on, on bank value

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without actually looking at the value itself.

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What we do, instead of looking at, you know,

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interest rates versus cost, we look at net outcome,

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the net result, and the corporate theory will tell you,

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and any corporate finance basic theory will tell you that

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any good decision, by a company should

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manifest itself in market premium.

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So, in other words, if I'm doing something right,

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the market participants should appreciate it

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and it should show up

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as an increase in the value of my company.

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Unlike other studies that show only interact mixed evidence,

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we focus on value added

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from the relationship loans, from business loans.

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So our logic is very simple.

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Again, if the revenue exceed the cost,

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then it should actually show up in the market risk premium.

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So our main hypothesis is that small business lending

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by banking and organizations is value enhancing,

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and as a result is associated with the market premium.

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They're using, multiple data sources.

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So, well, of course we need, the,

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the balance sheet and income statement data for banks,

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because ultimately what we do, we try

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to separate small business loans, large business loans,

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different other types of assets and liabilities, and,

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and attribute the market premium to those particular,

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assets.

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So we need income statement and balance sheet,

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and we are getting that from, regulatory violence.

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So-called, call reports

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and FR Y nine Cs, those are, US based of course,

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and call reports is just for individual bank.

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And ffr, Y nine C is

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for banking organization, bank holding company.

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So some banks operate as standalone institutions.

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Some banks operate as conglomerates, bank holding companies,

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so it doesn't really matter eventually,

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it's just different type of reports.

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So for standalones, we use call reports for,

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holding companies.

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We use Y nine Cs, but those are regulatory violence.

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Then we need to match that with the, the stock price

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of, of those banking organizations.

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So we use CRSP, which is Center for Financial Research

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and Security Prices out of University of Chicago dataset.

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And finally, I think the, the most interesting innovation

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of our study is that we also look at market premium

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for non publicly traded banks.

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If you're a publicly traded bank,

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your market premium is easily observed

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because you just look at the stock price.

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But if you're non publicly trade, small community bank,

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the one that is the most likely to engage in,

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relationship lending for those banks,

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the stock prices are not observed.

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So how can we figure out

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the market premium if there is no market?

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Well, we use this idea

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that even though small banks are not publicly traded,

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sometimes they're acquired by some other banks in mergers

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and acquisition transactions.

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And if that happens, then the acquirer actually pays the

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price for a particular bank.

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And that's when we observe that market value of that bank.

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And for that, we use Capital IQ platform.

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So Capital IQ is a market intelligent platform designed

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by standards and pos.

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It collects, a lot of information including m

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and a transaction data.

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We have two samples. One is m and As,

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and that's where we look at the market premium, in,

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mergers and acquisition transactions.

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And then we have the sample of publicly traded banks when we

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simply look at stock prices.

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So then once we collect all the data,

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we have a model which we borrow from,

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from accounting research that has market value

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of equity on the side,

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and it has book value of different assets

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and liabilities on the right hand side.

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And when you run those regressions, the coefficients on each

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of those asset categories show the actual market

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to book value ratio

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or market premium associated with a particular asset.

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00:10:06.745 --> 00:10:10.565
And if that coefficient is greater than one, we say

210
00:10:10.565 --> 00:10:12.725
that the asset adds value to the firm.

211
00:10:12.785 --> 00:10:13.805
If it's less than one,

212
00:10:13.805 --> 00:10:16.765
then it actually subtract the value in that setting.

213
00:10:17.385 --> 00:10:20.725
Uh, we are looking at the coefficients of market

214
00:10:20.865 --> 00:10:23.845
to book value ratio associated with small business loans,

215
00:10:23.845 --> 00:10:25.285
commercial and industrial loans,

216
00:10:25.285 --> 00:10:27.125
because those are the loans that are most likely

217
00:10:27.125 --> 00:10:28.445
to be relationship based.

218
00:10:28.665 --> 00:10:32.045
We actually find that, those small, commercial

219
00:10:32.145 --> 00:10:36.325
and industrial loans, add market value to the banks,

220
00:10:36.465 --> 00:10:37.605
and more importantly,

221
00:10:38.155 --> 00:10:41.445
they add more value than larger commercial industrial loans,

222
00:10:41.445 --> 00:10:42.685
which are more transaction based.

223
00:10:43.025 --> 00:10:46.325
So in other words, the relationship lending small, small,

224
00:10:46.455 --> 00:10:48.485
small loans are really value enhanced.

225
00:10:49.185 --> 00:10:51.605
Now, if you wanna put a number on it, we show that

226
00:10:51.665 --> 00:10:55.725
for the smallest category of those loans, $1 of book value

227
00:10:56.345 --> 00:11:00.605
is associated with one point $39 acquisition price.

228
00:11:01.065 --> 00:11:02.965
So in other words, when, when I'm a bank

229
00:11:02.965 --> 00:11:06.045
and I'm buying another bank, I'm willing

230
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to pay 39% market premium

231
00:11:09.705 --> 00:11:13.285
on small business loans held by my target,

232
00:11:13.385 --> 00:11:14.525
my target institution.

233
00:11:14.815 --> 00:11:17.685
There is a very, very significant, market premium.

234
00:11:18.185 --> 00:11:20.725
So our interpretation is that, you know,

235
00:11:20.745 --> 00:11:22.365
the added revenue associated

236
00:11:22.365 --> 00:11:24.725
with the relationship planning exceeds the additional

237
00:11:24.725 --> 00:11:27.325
information cost associated with evaluating

238
00:11:27.345 --> 00:11:28.925
and monitor of small business loans.

239
00:11:29.705 --> 00:11:31.605
Now, what's also important is

240
00:11:31.605 --> 00:11:33.765
that the value enhancing effect

241
00:11:33.765 --> 00:11:35.845
of small business loans is present not only

242
00:11:35.845 --> 00:11:37.565
during normal economic conditions,

243
00:11:37.565 --> 00:11:39.045
but also during tough times.

244
00:11:39.785 --> 00:11:41.925
In particular, during the global financial crisis

245
00:11:42.145 --> 00:11:43.925
of 2007, 2009.

246
00:11:44.545 --> 00:11:46.085
That's also very important finding

247
00:11:46.085 --> 00:11:50.645
because it demonstrates that, you know, the ability

248
00:11:51.545 --> 00:11:54.245
of small community banks to evaluate, monitor,

249
00:11:54.465 --> 00:11:55.805
and establish relationships

250
00:11:55.805 --> 00:11:58.485
with their customers really pays off during,

251
00:11:58.585 --> 00:12:01.565
during tough times, because that's the time when the demand

252
00:12:01.565 --> 00:12:03.165
for those loans says is the highest.

253
00:12:03.945 --> 00:12:06.485
And those community banks have those customers,

254
00:12:07.155 --> 00:12:08.685
they know them, and

255
00:12:08.825 --> 00:12:11.605
during tough times when loan demand is going up,

256
00:12:11.655 --> 00:12:15.005
those banks can basically exploit their information

257
00:12:15.325 --> 00:12:16.485
monopoly power even more.

258
00:12:17.795 --> 00:12:21.085
Also, we find that there is no real evidence

259
00:12:21.115 --> 00:12:25.445
that the technological advancement like FinTech lending,

260
00:12:25.825 --> 00:12:29.125
really deteriorate any, any of those market premiums.

261
00:12:29.125 --> 00:12:32.165
So in other words, there was a lot of concern,

262
00:12:32.225 --> 00:12:34.525
in the industry that FinTech might actually

263
00:12:34.555 --> 00:12:36.285
displaced some of the banks.

264
00:12:36.785 --> 00:12:38.205
Uh, that's not what we find.

265
00:12:38.385 --> 00:12:39.805
And our interpretation is

266
00:12:39.805 --> 00:12:42.125
that FinTech lending is more transaction based.

267
00:12:42.155 --> 00:12:43.525
It's not relationship based.

268
00:12:44.115 --> 00:12:48.525
It's based on very specific criteria, your credit score,

269
00:12:48.525 --> 00:12:51.365
your collateral, something that is observable,

270
00:12:51.955 --> 00:12:55.085
what those community banks do, they look at,

271
00:12:55.475 --> 00:12:57.405
some intangible soft information.

272
00:12:57.585 --> 00:12:59.805
And FinTech does not compete with that.

273
00:13:00.305 --> 00:13:03.525
So we find no evidence that, the, the, the, the,

274
00:13:03.985 --> 00:13:07.005
you know, the development of FinTech industry somehow

275
00:13:07.515 --> 00:13:08.965
influence that market premium.

276
00:13:09.185 --> 00:13:12.365
We find that the commercial real estate loans are not

277
00:13:12.365 --> 00:13:14.485
associated with market premium, and that's

278
00:13:14.485 --> 00:13:17.525
because those loans are more transaction based.

279
00:13:17.525 --> 00:13:19.045
They're a lot more collateral based.

280
00:13:19.105 --> 00:13:23.765
So again, if I wanna, you know, use my,

281
00:13:24.865 --> 00:13:26.965
you know, renovate my warehouse,

282
00:13:27.185 --> 00:13:29.725
and I use that warehouse as a collateral,

283
00:13:30.355 --> 00:13:31.845
then there is no necessarily need

284
00:13:31.845 --> 00:13:32.925
for relationship based lending

285
00:13:32.925 --> 00:13:34.845
because that warehouse is a collateral.

286
00:13:35.105 --> 00:13:36.245
You know, you observe the value,

287
00:13:36.305 --> 00:13:37.525
you know exactly what it is.

288
00:13:37.905 --> 00:13:40.085
So you're not worried about credit quality as much.

289
00:13:40.505 --> 00:13:44.085
On the other hand, if I borrow money in order to, you know,

290
00:13:44.155 --> 00:13:45.605
open my restaurant

291
00:13:46.385 --> 00:13:50.125
and I have no idea how my cash flows are gonna be,

292
00:13:50.545 --> 00:13:52.405
now it's important for community banks

293
00:13:52.405 --> 00:13:54.965
to really read the business plan, to understand what,

294
00:13:54.965 --> 00:13:56.405
what the customer is gonna be like,

295
00:13:56.475 --> 00:13:57.925
what the cash flows are gonna be.

296
00:13:57.925 --> 00:13:59.565
So that's where the most value is coming from.

297
00:14:00.505 --> 00:14:04.845
So again, very strong support for the,

298
00:14:05.105 --> 00:14:06.645
the value of relationship lending

299
00:14:07.705 --> 00:14:12.525
and, not much support for, value of,

300
00:14:12.525 --> 00:14:14.365
lending that is transaction based.

301
00:14:14.785 --> 00:14:16.925
The main implication is that, like you said,

302
00:14:16.925 --> 00:14:17.965
the ship has not sailed.

303
00:14:17.965 --> 00:14:19.445
The community banks are important.

304
00:14:19.595 --> 00:14:21.565
They are vital to small businesses,

305
00:14:21.825 --> 00:14:24.045
and their business model is working.

306
00:14:24.585 --> 00:14:27.765
And we have a lot of anecdotal evidence that, that

307
00:14:27.765 --> 00:14:28.845
that's exactly what it is.

308
00:14:28.905 --> 00:14:31.405
In fact, I just came back from, a community bank

309
00:14:31.405 --> 00:14:32.445
and research conference

310
00:14:32.545 --> 00:14:35.645
and, I got a lot of feedback from community bankers,

311
00:14:35.645 --> 00:14:38.485
and they all say that that's exactly what they think

312
00:14:39.465 --> 00:14:41.565
the the relationship model works.

313
00:14:42.025 --> 00:14:44.725
Um, they are pretty happy with their business model.

314
00:14:45.115 --> 00:14:48.245
However, they're facing significant,

315
00:14:48.275 --> 00:14:50.165
headwinds from regulatory

316
00:14:50.765 --> 00:14:54.805
Pressure, from, adoption of technology, not, not

317
00:14:54.805 --> 00:14:56.685
as a competition, but more of the cost

318
00:14:56.685 --> 00:14:59.365
of adopting technology risk management, for instance,

319
00:14:59.585 --> 00:15:02.365
and also significant pressure from, acquisitions,

320
00:15:02.365 --> 00:15:03.525
from mergers and acquisitions.

321
00:15:04.105 --> 00:15:08.205
So what's interesting is, again, in our study, we do find

322
00:15:08.205 --> 00:15:12.285
that the acquirer is willing to pay market premium.

323
00:15:13.185 --> 00:15:14.525
But the next question is,

324
00:15:15.795 --> 00:15:17.685
when they acquire those community banks,

325
00:15:18.945 --> 00:15:20.765
do they maintain those relationships?

326
00:15:21.585 --> 00:15:22.605
Do they continue?

327
00:15:22.945 --> 00:15:26.325
Do they let them continue, do what they do best?

328
00:15:26.825 --> 00:15:30.725
So for example, if bank A acquires bank B,

329
00:15:31.835 --> 00:15:34.095
and now it becomes just bank A.

330
00:15:34.195 --> 00:15:37.855
So bank B becomes just a subsidiary of, of, of, of bank A

331
00:15:38.765 --> 00:15:42.695
does bank a let that subsidiary continue the same model and,

332
00:15:42.695 --> 00:15:45.615
and do relationship planning and extract value that way.

333
00:15:46.595 --> 00:15:49.535
So for the future research, we, we, we, we wanna see

334
00:15:49.535 --> 00:15:51.175
what happens after those mergers.

335
00:15:51.675 --> 00:15:53.135
So in this study, we don't do it,

336
00:15:53.135 --> 00:15:54.855
we just look at the market premium itself,

337
00:15:54.855 --> 00:15:56.295
but we wanna go further

338
00:15:56.475 --> 00:15:59.855
and see, do acquirers actually maintain relationship lending

339
00:16:00.395 --> 00:16:02.695
and how overall bank consolidation

340
00:16:03.355 --> 00:16:04.815
may affect relationship lending

341
00:16:04.995 --> 00:16:07.135
and the, the overall small business lending,

342
00:16:07.565 --> 00:16:10.695
because a lot of those community banks are actually being,

343
00:16:10.825 --> 00:16:13.695
being acquired and not many community

344
00:16:13.695 --> 00:16:15.455
banks are being created.

345
00:16:15.685 --> 00:16:17.495
Very few community bank startups.

346
00:16:17.495 --> 00:16:19.455
And the, the, the, the, the main factor

347
00:16:19.475 --> 00:16:20.775
to blame is regulation.

348
00:16:21.155 --> 00:16:22.815
The regulation is really draconian.

349
00:16:22.915 --> 00:16:24.015
And you know, especially

350
00:16:24.015 --> 00:16:26.535
after Dodd-Frank, there is a lot of pressure.

351
00:16:26.565 --> 00:16:28.815
It's very difficult to open a new bank these days,

352
00:16:29.275 --> 00:16:31.055
but on the other hand, they're being acquired,

353
00:16:31.315 --> 00:16:32.975
so we have fewer banks.

354
00:16:33.635 --> 00:16:36.535
And, as a result, the question is, you know,

355
00:16:37.075 --> 00:16:38.255
what's gonna happen in the future?

356
00:16:38.315 --> 00:16:39.535
So that's what we're gonna look at.

Challenges of Banking: Borrower Identification and Relationship Dynamics

00:00:00 - One of the biggest challenges in banking is identifying good borrowers and pricing loans properly. And the less the bank knows about the borrower, the harder it is for a bank to make a proper credit decision and price it correctly. So it is called assymetry of information between a borrower and a lender. So when the borrower is a large publicly traded company, the information is there, there are disclosure requirements, there are analysts who follow the firm. there is media coverage, so it's easy for a bank

00:00:34 - and, and price the loan correctly. But when we are talking about small borrowers that are non-transparent, opec, mostly non-publicly traded businesses, it's very difficult to to figure out the, the riskiness and, and projected cash flows. So now what happens is with, with those borrowers, banks need to develop relationships, and that's exactly what community banks do. They established and they cultivate the,

00:01:05 - and they strive on that relationship based, business model. So they know their customers, they take genuine interest in their business plans. They come to visit, they come to the sites before they make loan decisions. So over time, when they acquire this, so-called soft information, they create a monopoly on that information and subject their customers to, so-called hold up cost. So hold up cost means that the customer wants it locked in

Evaluating the Value of Relationship-Based Lending

00:01:38 - that customer to switch to another bank later on. So, you know, utilizing that hold up, problem and basically the monopoly power on information, the banks eventually are able to extract extra revenue and extra earnings by lending to those customers at a rate that might be higher than the competitive interest rate. On the other hand, it is expensive process to acquire that information. So even though the banks might get extra returns,

00:02:12 - with acquiring that information. So the question becomes, is it a valuable thing to do? Is it valuable thing to do to actually establish those relationships with customers and, you know, operate with relationship based business model? Well, in the end of the day, it's basically the extra revenue versus extra cost. And ultimately what is going to happen is

00:02:43 - then we should see it, in market risk premium, excuse me, in in market premium associated with small business lending. So what we do, we actually, you know, try to estimate whether relationship based lending is associated With market premium, right? In other words, if markets are willing to pay extra for every dollar of small business loans, and that way we address this question of whether relationship planning is actually valuable.

Analyzing Bank-Borrower Relationships: Benefits and Mechanisms

00:03:14 - because if you think about it, there are, there are two sites. There is a bank, and then there is a borrower or the firm. And most of the literature focused on how firms benefit from bank relationships. And there are studies that demonstrated that, due to that relationship based, model, the firms get, additional access to credit. So it's increased credit availability, more favorable contract terms. And even for larger firms, the bank relationships,

00:03:48 - For example, when large company obtains a big loan for a bank, the stock market views it as a positive signal, and the, the stock price of a company goes up because market believes that the bank did their job. They looked at that firm, they figure out it's a good risk. So markets view it as a positive signal. On the other hand, if the company, you know, stops bank relationship, if the bank drops the firm, then it's a, it's a stigma.

00:04:17 - So all in all, it's pretty conclusive evidence in the literature that firms do benefit from bank relationships. However, there is a lot less in the literature on how banks benefit from it. And one of the mechanisms, is through this holdup, problem. and, and as a result, the, the banks are supposed to raise interest rates as relationships continue. So most of the studies, on value to banks

Interest Rates and Relationship Lending Dynamics

00:04:50 - So they look at how interest rates change over the course of, of, of relationships, with a particular firm, and they find mixed evidence. Some studies do find that interest rates go up over time, which allows the, the banks actually to, to utilize their monopoly power. Some studies find that interest rates don't change, and some studies find that interest rates actually go down.

00:05:18 - to interpret because it's, it's not only about interest rates, it's also about the actual cost of monitoring those customers. And over time, as the relationship progresses, the cost of monitoring may actually go down. And as a result, the banks don't necessarily have to raise interest rates. They may keep them constant or even allow the customers to get a little bit of a discount because the cost of monitoring is going down. So it's basically revenue minus cost. And because the costs are unobservable, it's very difficult

00:05:54 - of relationship lending on, on, on, on bank value without actually looking at the value itself. What we do, instead of looking at, you know, interest rates versus cost, we look at net outcome, the net result, and the corporate theory will tell you, and any corporate finance basic theory will tell you that any good decision, by a company should manifest itself in market premium.

Impact of Small Business Lending on Market Value

00:06:27 - the market participants should appreciate it and it should show up as an increase in the value of my company. Unlike other studies that show only interact mixed evidence, we focus on value added from the relationship loans, from business loans. So our logic is very simple. Again, if the revenue exceed the cost, then it should actually show up in the market risk premium. So our main hypothesis is that small business lending

00:06:59 - and as a result is associated with the market premium. They're using, multiple data sources. So, well, of course we need, the, the balance sheet and income statement data for banks, because ultimately what we do, we try to separate small business loans, large business loans, different other types of assets and liabilities, and, and attribute the market premium to those particular, assets. So we need income statement and balance sheet,

00:07:30 - So-called, call reports and FR Y nine Cs, those are, US based of course, and call reports is just for individual bank. And ffr, Y nine C is for banking organization, bank holding company. So some banks operate as standalone institutions. Some banks operate as conglomerates, bank holding companies, so it doesn't really matter eventually, it's just different type of reports. So for standalones, we use call reports for,

Evaluating Market Premiums for Non-Publicly Traded Banks

00:08:01 - We use Y nine Cs, but those are regulatory violence. Then we need to match that with the, the stock price of, of those banking organizations. So we use CRSP, which is Center for Financial Research and Security Prices out of University of Chicago dataset. And finally, I think the, the most interesting innovation of our study is that we also look at market premium for non publicly traded banks. If you're a publicly traded bank,

00:08:34 - because you just look at the stock price. But if you're non publicly trade, small community bank, the one that is the most likely to engage in, relationship lending for those banks, the stock prices are not observed. So how can we figure out the market premium if there is no market? Well, we use this idea that even though small banks are not publicly traded, sometimes they're acquired by some other banks in mergers and acquisition transactions.

00:09:06 - price for a particular bank. And that's when we observe that market value of that bank. And for that, we use Capital IQ platform. So Capital IQ is a market intelligent platform designed by standards and pos. It collects, a lot of information including m and a transaction data. We have two samples. One is m and As, and that's where we look at the market premium, in, mergers and acquisition transactions.

Market Value Assessment of Small Business Loans

00:09:37 - simply look at stock prices. So then once we collect all the data, we have a model which we borrow from, from accounting research that has market value of equity on the side, and it has book value of different assets and liabilities on the right hand side. And when you run those regressions, the coefficients on each of those asset categories show the actual market to book value ratio or market premium associated with a particular asset.

00:10:10 - that the asset adds value to the firm. If it's less than one, then it actually subtract the value in that setting. we are looking at the coefficients of market to book value ratio associated with small business loans, commercial and industrial loans, because those are the loans that are most likely to be relationship based. We actually find that, those small, commercial and industrial loans, add market value to the banks, and more importantly,

00:10:41 - which are more transaction based. So in other words, the relationship lending small, small, small loans are really value enhanced. Now, if you wanna put a number on it, we show that for the smallest category of those loans, $1 of book value is associated with one point $39 acquisition price. So in other words, when, when I'm a bank and I'm buying another bank, I'm willing to pay 39% market premium

Value of Relationship Lending in Economic Challenges

00:11:13 - my target institution. There is a very, very significant, market premium. So our interpretation is that, you know, the added revenue associated with the relationship planning exceeds the additional information cost associated with evaluating and monitor of small business loans. Now, what's also important is that the value enhancing effect of small business loans is present not only during normal economic conditions, but also during tough times.

00:11:42 - of 2007, 2009. That's also very important finding because it demonstrates that, you know, the ability of small community banks to evaluate, monitor, and establish relationships with their customers really pays off during, during tough times, because that's the time when the demand for those loans says is the highest. And those community banks have those customers, they know them, and during tough times when loan demand is going up,

00:12:15 - monopoly power even more. Also, we find that there is no real evidence that the technological advancement like FinTech lending, really deteriorate any, any of those market premiums. So in other words, there was a lot of concern, in the industry that FinTech might actually displaced some of the banks. that's not what we find. And our interpretation is that FinTech lending is more transaction based.

Comparing Relationship Lending and Transaction-Based Lending

00:12:44 - It's based on very specific criteria, your credit score, your collateral, something that is observable, what those community banks do, they look at, some intangible soft information. And FinTech does not compete with that. So we find no evidence that, the, the, the, the, you know, the development of FinTech industry somehow influence that market premium. We find that the commercial real estate loans are not

00:13:14 - because those loans are more transaction based. They're a lot more collateral based. So again, if I wanna, you know, use my, you know, renovate my warehouse, and I use that warehouse as a collateral, then there is no necessarily need for relationship based lending because that warehouse is a collateral. You know, you observe the value, you know exactly what it is. So you're not worried about credit quality as much. On the other hand, if I borrow money in order to, you know,

00:13:46 - and I have no idea how my cash flows are gonna be, now it's important for community banks to really read the business plan, to understand what, what the customer is gonna be like, what the cash flows are gonna be. So that's where the most value is coming from. So again, very strong support for the, the value of relationship lending and, not much support for, value of, lending that is transaction based.

The Vital Role of Community Banks in Small Business Lending

00:14:16 - the ship has not sailed. The community banks are important. They are vital to small businesses, and their business model is working. And we have a lot of anecdotal evidence that, that that's exactly what it is. In fact, I just came back from, a community bank and research conference and, I got a lot of feedback from community bankers, and they all say that that's exactly what they think the the relationship model works. they are pretty happy with their business model.

00:14:48 - headwinds from regulatory Pressure, from, adoption of technology, not, not as a competition, but more of the cost of adopting technology risk management, for instance, and also significant pressure from, acquisitions, from mergers and acquisitions. So what's interesting is, again, in our study, we do find that the acquirer is willing to pay market premium. But the next question is,

00:15:18 - do they maintain those relationships? Do they continue? Do they let them continue, do what they do best? So for example, if bank A acquires bank B, and now it becomes just bank A. So bank B becomes just a subsidiary of, of, of, of bank A does bank a let that subsidiary continue the same model and, and do relationship planning and extract value that way.

Impact of Mergers on Community Banking and Small Business Lending

00:15:49 - what happens after those mergers. So in this study, we don't do it, we just look at the market premium itself, but we wanna go further and see, do acquirers actually maintain relationship lending and how overall bank consolidation may affect relationship lending and the, the overall small business lending, because a lot of those community banks are actually being, being acquired and not many community banks are being created. Very few community bank startups.

00:16:38 - to blame is regulation. The regulation is really draconian. And you know, especially after Dodd-Frank, there is a lot of pressure. It's very difficult to open a new bank these days, but on the other hand, they're being acquired, so we have fewer banks. And, as a result, the question is, you know, what's gonna happen in the future? So that's what we're gonna look at.

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