How does soft information about small business lending affect bank efficiency under capital regulation?

Abstract

In this paper, we develop a capped call option model to evaluate the equity of a bank under capital regulation. A capped type of credit risk from the performance of relationship borrowing firms is explicitly considered, captured by a mechanism through borrower soft information that the bank produces and accumulates. We study the impact of soft information for small business lending on the optimal bank interest margin, i.e., the spread between the loan rate and the deposit rate of a bank. Our findings show that favorable soft information increases small business lending at a reduced loan rate (and thus at a reduced margin), and further lowers bank equity risk and enhances efficiency gains from soft information acquisition when borrower dependent on bank financing is heavy. Moreover, we account for the capital regulatory environment stringent to small business lending that increases bank equity risk and decreases soft information efficiency gain. Our results have important bank interest margin implications in terms of achieving efficiency gain and lower risk exposure, which might conflict with capital regulation aiming to promote financial stability.