Lines of Credit and Relationship Lending in Small Firm Finance

This paper examines the role of relationship lending using a data set on small firm finance. The abilities to acquire private information over time about borrower quality and to use this information in designing debt contracts largely define the unique nature of commercial banking. Recently, a theoretical literature on relationship lending has appeared which provides predictions about how loan interest rates evolve over the course of a bank-borrower relationship. The study focuses on small, mostly untraded firms for which the bank-borrower relationship is likely to be important. The authors examine lending under lines of credit (L/Cs), because the L/C itself represents a formalization of the relationship and the data are thus more "relationship-driven." They also analyze the empirical association between relationship lending and the collateral decision. Using data from the National Survey of Small Business Finance, the authors find that borrowers with longer banking relationships pay a lower interest rate and are less likely to pledge collateral. Empirical results also suggest that banks accumulate increasing amounts of this private information over the duration of the bank-borrower relationship.