Firms as Monitors of Other Firms: Evidence from Sme Finance

Abstract

A large body of literature has shown that small firms, due to their opaqueness, may find it difficult to access the credit market. Informational asymmetries may be mitigated by posting collateral or by building relationships with lenders (relationship lending). However, in some cases, due to a lack of collateral or of a long credit history, small enterprises may still find it very difficult to raise external finance unless alternative contracting schemes emerge. In particular, group lending or similarly micro-finance are examples of such alternative lending contracts. In this paper, we investigate the effect of mutual loan guarantee consortia (MLGC) on loan interest rates. We argue that, similarly to group lending and micro-finance, firms affiliated to a MLGC are linked by a joint responsibility for the loan providing MLGC affiliates with peer monitoring incentives. Indeed, each MLGC member contributes to the guarantee fund that is then posted as collateral to loans granted to MLGC members. As a consequence, MLGC willingness to post collateral signals firms credit-worthiness to banks. The econometric analysis exploits a unique data-set extracted from the Italian Credit Register with 350,000 observations on bank loans to 260,000 SMEs. The main results support the hypothesis that MLGC improve lending conditions for small firms and are the following. First, small firms affiliated with a MLGC obtain finance at interest rates that are significantly lower than other small firms; the benefit is greater for small firms located in the South where asymmetric information problems are the most severe. Second, affiliated firms have a probability to go into default lower than other firms with the same characteristics; the probability to go into default drops considerably if the firm is located in the South. Third, an increase in the number of firms affiliated to a MLGC improves the peer-monitoring effect but up to a limit; when the number of borrowers in the group increases too much, the free riding problem overcomes the benefits of peer monitoring coming from additional firms.

Keywords: credit guarantee schemes, group lending, joint liability, microfinance, peer monitoring, small business finance

JEL Classification: D82, G21, G30, O16