Essays on Small Business Lending

This dissertation focuses on the role of lender-borrower relationships in small business lending. It consists of three essays. The first essay of this dissertation, titled "The Strategic Value of Lending Relationships," empirically investigates whether maintaining a long-term relationship with a lender can have negative consequences for a small business borrower. In the process of lending to a small business a lender acquires private information about the firm that is not available to other banks (non-lenders). The resulting lender-nonlender information asymmetry deters outside competition for the borrower firm, forcing the borrower to cede information rents (in the form of high interest rates) to its established lender. Over time, the firm's interest rates rise as the firm comes to be informationally captured by its old bank.;The first essay of this dissertation studies whether a long-term lender-borrower relationship can lead to information capture. I find that among firms who borrow from a single lender, loan interest rates increase with the duration of the lender-borrower relationship. In contrast, among firms who borrow from two or more lenders, the lender-borrower relationship has no effect on loan interest rates.;To account for the possibility that a firm's selection to borrow from a single lender is endogenous, I implement the methodology of Altonji, Elder, and Taber (2005). In the absence of a plausibly exogenous instrument, the methodology of Altonji, Elder, and Taber enables me to assess the degree of endogenous selection within my econometric model and to account for its influence on coefficients estimates. After accounting for endogenous selection, my estimates remain statistically and economically significant.;While a lender-borrower relationship can lead to information capture, lender-nonlender information asymmetry should be less common among firms who can more easily communicate their credit quality to a prospective, outside lender. I hypothesize that a borrower's attempt to communicate its credit quality to a prospective lender should be more successful in a small, rural market than in a large, urban market.;The transmission of information between a pair of agents requires multiple interactions. Since repeat interaction between a given pair of agents should be more common within a small population, a firm's efforts to communicate its credit quality to an additional prospective lender should be more successful in a smaller market. Consequently, information capture should be less likely in rural markets than in urban markets. My findings corroborate this prediction. I find that the adverse interest rate effect of a long lender-borrower relationship is weaker in small, rural markets than in large, urban markets.;The second essay of my dissertation, titled "Lender-Borrower Relationships and Price Discrimination in Small Business Lending," extends my first essay. My second essay investigates whether the market power obtained through information capture can allow lenders to price discriminate when making loans to long-standing borrowers. The essay shows that the interest rate paid by a single-lender borrower increases with the length of the lender-borrower relationship and that the magnitude of this increase is proportional to a firm's ability to pay, as proxied by firm profits and firm credit quality.;Since information capture generates market power I hypothesize that lenders should be able engage in first-degree price discrimination when setting interest rates for captured borrowers. A firm's willingness to pay for debt financing is determined by the expected value of the firm's business venture. Consequently, the interest rate premium charged to an informationally captured firm should be proportional to the viability and profitability of the firm. Confirming this hypothesis, I find that among firms who borrow from a single lender, the marginal effect of the lender-borrower relationship on loan interest rates increases with firm credit quality and firm profits.;The third essay of my dissertation, titled "Asymmetric Information and Loan Procurement in Small Business Lending," presents a game-theoretic model of small business loan procurement with asymmetric information among a borrower's potential lenders. The essay presents a model of information capture wherein the private information obtained by a lender through loan monitoring enables the lender to extract rents from the previously-monitored borrower.;The model shows that the market power obtained through information capture allows lenders to price discriminate when making loans to long-standing borrowers. Borrower monitoring allows a lender to discern a firm's willingness to pay for external funds, and a firm's willingness to pay for external funds is a positive function of expected future profitability. Consequently, the borrower firm pays high loan interest rates that are proportional to the firm's (publicly unobservable) credit quality and expected profits.