Hidden gems and borrowers with dirty little secrets: Investment in soft information, borrower self-selection and competition

Abstract

Hidden gems and borrowers with dirty little secrets: investment in soft information, borrower self-selection and competition ECB Working Paper, No. 1555 Provided in Cooperation with: European Central Bank (ECB)Suggested Citation: Gropp, Reint; Gruendl, Christian; Guettler, Andre (2013) : Hidden gems and borrowers with dirty little secrets: investment in soft information, borrower self-selection and competition, ECB Working Paper, No. 1555, European Central Bank (ECB) We focus on the difference between firms with positive soft information and firms with negative soft information. Recent theoretical models (Hauswald and Marquez, 2006;Inderst and Mueller, 2007) suggest that firms with positive soft information would tend to self-select to relationship banks, because relationship banks can take the positive private signal into account in the lending decision. This creates an Akerlof-type adverse selection problem, in which transaction banks tend to receive applications from borrowers with on average negative soft information. In response, transaction banks may apply a negative adjustment to the rating of all their loan applicants. However, if they do, even borrowers with slightly negative private information may be better off obtaining a loan from a relationship bank, resulting in an even worse pool of loan applicants with respect to the private signal and so forth. Ultimately, in the absence of any offsetting factor, transactions banks would no longer participate in the market for small business loans and some positive NPV firms may no longer receive credit. The selection effect may explain why banks ultimately specialize in either relationship or transaction banking.Furthermore, theory would predict that there are interaction effects with the degree of interbank competition. In particular, Boot and Thakor (2000) argue that there are two effects. When competition is introduced, banks' marginal rents from relationship lending are smaller and each bank thus reduces its investments in soft information. However, competition affects the bank's profits from both relationship and transaction lending asymmetrically. A relationship orientation helps to partially insulate the bank from pure price competition, so that an increase in competition from other banks hurts the bank's profits from transaction lending more than its profits from relationship lending. Thus, increased competition between banks may encourage banks to shift from transaction to relationship lending.We use a matched bank-borrower dataset of German savings banks to test these predictions.These banks provide an ideal laboratory, as they compete with pure transaction banks, such as 2 Deutsche Bank and with pure relationship banks, such as the large number of extremely small cooperative banks in Germany. At the same time, there is sufficient variation within the savings bank sector in the degree to which banks incorporate soft information in their lending decisions.Most importantly, the dataset allows us to construct a proxy for the case when the private no...

Money Creation and Destruction

“…Costs of monitoring typically constitute a major part of a private bank's expenses, a statement supported by empirical evidence from Philippon (2012) and Gropp et al (2013). Moreover, economizing on these costs constitutes one rationale for the existence of banks.…”

Asset Price Bubbles and Systemic Risk

“…Several studies analyze how investment behavior depends on social connections. 2 Yet, despite banks actively relying on soft information for their lending decisions (Uchida, Udell, and Yamori, 2012;Liberti, 2018;Gropp and Güttler, 2018), and despite particularly pronounced information frictions between borrowers and lenders, the relevance of social connections as an information channel for bank-lending decisions has hardly been analyzed. La Porta, López de Silanes, and Shleifer (2002) and Khwaja and Mian (2005) show that political connections drive lending decisions.…”

Communication frictions in banking organizations: Evidence from credit score lending

“…In fact, recent studies indicate that the "hardening" of soft information in credit scoring encounters significant limits reflecting communication frictions within the bank's organizational hierarchy (Brown et al, 2015;Gropp and Guettler, 2018). In particular, in a companion paper we show that spatially-based organizational frictions (proxied by the functional distance between the loan officer 2 compiling the credit score and the bank's headquarters) affects the propensity of loan officers to "harden" soft information in credit scoring and the approval time for applicants (Filomeni et al, 2020).…”