Abstract
Despite being informationally opaque, small firms often switch from their primary financial institution to transactional lenders, with the relationship banking theory invoking the holdup problem as a culprit explanation. Using US evidence and an estimation strategy that overcomes traditional shortcomings in small business research, our study captures the determinants and, for the first time, the ex post effects of the switching decision. We find that switching is less likely when the primary financial institution is a nearby bank associated with quality services and connected to the firm via other business or social relationships. Small firms become more loyal as they grow in size and pursue nonmortgage credit. Outside the primary relationship, both loan approval and borrowing cost are adversely impacted, however loan maturities are longer. Moreover, the likelihood of pledging collateral remains unaffected, provided that the type of collateral is least sensitive to the borrower’s information environment. Jointly, our findings describe a trade-off inconsistent with the holdup problem, and an opportunity for banks to enhance customer loyalty by improving aspects of the relationship unrelated to the terms of credit.
Highlights
Asymmetric information plays an important role in determining the financing choices of small businesses (Ang 1991; Crawford et al 2018)
This study investigates the determinants and implications of bank switching in the area of small businesses
The small firm’s borrowing decision oscillates between two axes: (1) the primary financial institution, which maintains an informational advantage and provides relationship-based lending; and (2) nonprimary financial institutions, which operate at arm’s length and issue loans on a transactional basis. Switching from the former source of finance to the latter is to effectively opt out from relationship banking, foregoing the time and cost committed to bridge the informational wedge with the main bank
Summary
Asymmetric information plays an important role in determining the financing choices of small businesses (Ang 1991; Crawford et al 2018). Aligned with the comparative advantage of banks in lending to informationally opaque enterprises, switching is less probable when the primary financial institution is a bank With these exceptions, we document the irrelevance of most other theoretically identified variables relating to owner, firm and banking market characteristics. We maintain an exclusive focus on small businesses, i.e., the type of firms for which bank credit matters the most This approach stands in contrast to the samples used in Ongena and Smith (2001), Farinha and Santos (2002), Ioannidou and Ongena (2010), Barone et al (2011), Gopalan (2011) and Bonfim et al (2021), which include larger firms that have a menu of financing options inaccessible to their smaller counterparts.
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