Within the entrepreneurship literature, a considerable amount of research has been devoted to the role of the venture capital industry and more recently 'business angels' in financing enterprise. While external equity is clearly important, particularly in some of the high-risk/high-return areas of business activity, the majority of businesses continue to rely heavily on the banking sector for finance. This is particularly so in the case of smaller businesses. Although not all smaller businesses are entrepreneurial a significant amount of entrepreneurial activity is manifest among their activities.
Credit rationing (as a consequence of information asymmetries) is often identified as a factor constraining the development of the more entrepreneurial smaller businesses. The theoretical basis for credit rationing is well established although its empirical significance has been subject to rather more debate. To the extent that credit rationing exists, the provision of collateral can be seen as a device to mitigate the effects of the information asymmetries which are its cause. However, collateral is not the only mechanism for addressing the problem of information asymmetries; while perfect information may be an unobtainable goal, information flows between a business and a bank can be improved by the development of a closer working relationship. Such relationships are, by definition, two way and a truly effective relationship is likely to require the active commitment and participation of both parties.
Despite the apparent importance of bank finance, the issue of banking relationships has been relatively under-researched, particularly in the context of smaller and more entrepreneurial businesses. This paper explores the nature of banking relationships and assesses the benefits which may arise when these are closer and more participative. Section 2 of the paper provides a brief overview of the issues relating to the provision of finance while section 3 examines the nature of banking relationships and participation in more detail. The nature of customer relationships in the UK banking sector is discussed briefly in section 4 and section 5 presents the results of the empirical analysis. A summary and conclusions is provided in section 6
THE PROVISION OF FINANCE TO SMALL BUSINESSES
The majority of smaller, entrepreneurial businesses rely on bank debt rather than external equity as their major source of external funds (Keasey and Watson, 1992; Scherr, Sugrue and Ward, 1993), not least because the evaluation and monitoring costs associated with venture capital set a lower bound to the size of project which could be funded. Consequently, to the extent that finance may constrain growth, it is the efficiency and effectiveness of the provision of bank finance (rather than finance from other sources) which may be of particular interest. While the lack of adequate external finance may constrain growth, there is also evidence to suggest that the presence of external finance such as bank debt may have beneficial effects on performance (Keasey and McGuiness, 1990; Keasey and Watson, 1992) due to better evaluation and monitoring. However, the effectiveness of these two processes and more generally the provision of debt is, inter alia, dependent on the quantity and quality of information flows between the two parties.
The issue of information asymmetry and its implications for the provision of bank finance have been the subject of extensive discussion. From a theoretical perspective, it is commonly accepted that information asymmetry results in credit rationing (Stiglitz and Weiss, 1981) although an alternative perspective suggests that the true problem may be an oversupply of credit (de Meza and Webb, 1987). Empirically, the evidence is ambiguous. Evans and Jovanovic (1989) and Holtz-Eakin et al (1994) present evidence to indicate that there is a capital constraint with respect to start-ups which does not appear to be reduced through the provision of bank finance. However, UK evidence (Cressy, 1996) suggests that this type of constraint is not significant and that bank lending decisions reflect evaluations of human capital rather than any implicit, information based credit rationing. An intermediate position is adopted by Berger and Udell (1992) who argue that while the macro effects of credit rationing may be small, there is evidence to suggest that when credit is rationed to some firms it may be more readily available to others.
Clearly, there is considerable potential for further work to examine these issues; nevertheless it is worth noting that some of the apparent inconsistencies may be related to the role of collateral in bonding debt finance. Theoretically, adequate collateral can mitigate problems of asymmetric information (Bester, 1987); the low-risk borrowers who leave the market in the Stiglitz-Weiss model can signal their status by a willingness to offer appropriate levels of collateral, and the taking of collateral by the banks can provide an incentive to ensure that the firm will perform to the best of its abilities in undertaking the project (Bester, 1987). However, this solution in turn depends upon the availability of collateral. If collateral is in limited supply, debt gaps may still exist and there are reasons for believing that growing businesses may be particular vulnerable to this problem (Binks and Ennew, 1996)
Thus, theoretically and empirically there is evidence to suggest that information asymmetries may create problems in the financing of smaller, more entrepreneurial businesses and that collateral may ease these problems in some instances. A key characteristic of collateral is its information content-ie its ability to signal the entrepreneurs confidence in themselves and their proposals. If there are alternative means of enhancing information quality and quantity, they too may serve to ease some of the potential problems with the provision of debt finance. Clearly, perfect information is an unobtainable goal, but a close working relationship between bank and business can significantly improve information availability (Berger and Udell, 1993; Sharpe, 1989). A close relationship has the potential to provide the bank with a better understanding of the operating environment facing a particular business; a clearer picture of the managerial attributes of the owner and a more accurate overview of the prospects for the business. Thus, from the perspective of the bank, the relationship provides the basis for understanding customer needs and resources and identifying the most appropriate ways of meeting those needs.
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Last Updated 06/06/98