Information Externalities and Small Business Lending by Banks: A Comparison of Urban and Rural Counties in the U.S.

Abstract

It is widely recognized that small business is not only an important source of employment but is the genesis of virtually all successful large enterprises. Given their size and characteristic opaqueness, Small and Medium Enterprises (SMEs) tend to be more financially constrained than large firms because of the lack of access to external financing from both banks and capital markets. Though building a relationship provides the loan officer more information about the individual entrepreneur, there are other factors that can influence the success or failure of an enterprise. We divide the entrepreneurial information available to bank loan officers into three segments: information about competition in the local banking market, information about success and failures of other SMEs in the local market, and information about how well other banks are performing in the local market. The primary purpose of our paper is to find proxies for this entrepreneurial information and to gauge its impact on bank lending in a geographical area. We then test to see how our proxies for this information impact the dollar volume of small business lending. Our analysis uses county level data as the geographical area and controls for general economic conditions such as the level of income and the endowments of human capital. The paper confirms the importance of entrepreneurial information in influencing the level of SME lending by banks.