A Multistage Model of Loans and the Role of Relationships

Abstract

We develop a multistage model of the loan granting process to understand the contradictory findings of the existing literature on bank-borrower relationships, credit availability, and loan rates. Upon estimating our model with the 1993, 1998, and 2003 versions of the Survey of Small Business Finances data set, we find that relationships matter in a borrower's decision whether to apply for a loan and in the loan approval/rejection decision by the financial institution. However, the effect of relationships on loan rates depends on the prevailing economic climate. While firms with pre-existing relationships obtain credit at lower rates during periods of economic expansion, loan rates are not negatively correlated with pre-existing relationships during periods of economic recession.

Keywords: relationships, loan, small business, adverse selection, moral hazard, credit rationing

JEL Classification: C30, G20