Periods of financial distress

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On one hand, it is recommended that the firm which want to refinance should stay with its existing lender as the long-term relationship is proposed to be a benefit for both banks and firms. Mayer (1988) (cited in D’Auria) argued that countries with bank-dominated financial systems, such as Germany and Japan, have experience higher economic growth than those with the most advanced and competitive financial markets.

For the firms, Boot and Thakor( cited in Hanley) describe all banks initially charge high interest rates to first-time borrowers, once the lender has survived the first lending period, the lender will relax the interest margin and the collateral requirements. Indeed, an evidence suggests those smaller firms with well-established relationships with their lenders are less likely to be liquidity-constrained (D’Auria, 1999). For the banks, a long-term credit relationship provide the bank with better information about the firm’s financial position and prospects and makes it convenient to support credit worthy companies even in periods of financial distress.

On the other hand, both Sharpe (1990) and Rajan (1992) (cited in Hanley) point out there might be a hold-up problem because long-term relationships provide the bank an informational advantage, which reduces the strength of competition from other intermediaries, and hence bank can choose to use its monopoly power to squeeze the profits of the informationally captive firm by charging higher interest rates. In a 1995 paper, based on 1277 firms, Petersen and Rajian(cited in D’Auria)find a negative correlation between the interest rate and the firm’s age for each level of the concentration index and they interpret this result as evidence of the existence of the hold-up problem.

Diamond (1991) and Houston and James (1996) (cited in D’Auria) suggest that larger companies can easily diversify their external financing to reduce the hold-up problem. In the contrast, small firms do not have the reputation to obtain credit from different sources and have to rely on a single bank. Once the firm meet the hold-up problem and tries to switch bank, other banks normally will consider it as a bad borrower and reject the application. This case is what we called lemon problem. Sharpe proposed that the hold-up problem to small firms can only solved when the banks concentrate more on its reputation rather than on the profits.

Whereas, the small firm apply for the first loan is not definitely riskier than the firm want to refinance because there are other factors influence the decisions. Cole suggested one of the factors is the type of industry. Anecdotal evidence suggests that bankers often use industry classification in assessing borrower credit quality, and may not lend to firms in certain industries when those industries are under financial distress (Cole, 1998). However, Martin Binks et al. (1990) conclude that the knowledge of industry is still too little as they work out a result of high demand on being known more about the industry by small and new firms in their research.

Secondly, the organizational form is one of the factors because the degree of informational asymmetry may vary with organizational form, as the agency conflicts between owners, managers and creditors(Cole,1998) Indeed, higher growth is associated with higher rejection probability because excessive early growth drains the enterprise of cash flow, thereby might cause entrepreneur default on his repayment(Cole, 1998) Furthermore, Hanley (2003) also found that the firm characteristics affect the decision deny credit. More sanguine entrepreneurs, who see no risks that would disturb their business projects, are more likely to receive credit than pessimistic entrepreneurs. Finally, the bank prefers lending to business can operate in the absence of the principal owner, as evidenced by the higher proportion (73 percent) of applicants in the group who receive finance (Hanley, 2003).

To sum up, the small business applies for fist loan is recognised as higher risk are mainly based on three factors, which are the zero length of pre-existing relationship, zero firm age and small firm size. In order to increasing the probability of success, this new firm can choose either providing higher value collaterals or require small amount of loans. Although the firm that want to refinance with existing lender is expected to benefit from easy access of loans and lower interest margins, it needs to consider the existence of hold-up problem. In fact, we fin that some other factors, which can prove that the small and new firms are not always riskier than the existing firms, are not been investigated by banks. Therefore, it is suggested that banks should do more investigation and hence will be fairer to small and new firms.

Bibliography

1. Beter, H., (1985) ‘Screening vs. rationing in credit markets with imperfect information’, The American Economic Review, Vol.75 No.4,pp850-855

2. Binks, M., Ennew,C. and Reed, G. (1990), ‘Asymmetric information and the bank/small firm relationship in the UK’, NUBS Discussion Paper no.90/1

3. Cole, R, (1998) ‘the importance of relationships to the availability of credit’, Journal of Banking and Finance, Vol22, no6-8, pp959-977.

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