Risk management and Decisions

In the credit market, the major problem is the risk of lending, which mainly refers to asymmetric information. From some points, as Besanko and Thakor and Bester argued borrower knows more than the lender, because the bulk of private information, such as details of investment on projects, resides with the borrower and the lender must somehow devise a way to predict whether the borrower is going to meet her repayments( Lecture notes).

But from some aspects, argued by Meza and Southey et al., the lender knows more than the borrower because bank has great amounts of information that it has collected over the lifetime of the borrower and the lifetime of similar borrowers, thus it can calculate the probability that the borrower will default better than the borrower (Lecture notes). For the banks, they normally reduce the risk by examining two angles of information, which are private and public. Therefore, the fact of that small business looking for a first time loan with a new bank lender is perceived as higher risk than a business who wishes to refinance with its existing lender can be also explained in these two aspects. 

Firstly, this bank wants to develop private information from both of them. The main tool will be the pre-existing relationship with potential lender, which is identifies as the proxy for private information by Cole who found that pre-existing relationship generate valuable private information.

This can be also supported Berger and Undelll (cited in Cole) and Petersen and Rajan (cited in Cole) and Hanley, who all have examined the importance of the pre-existing relationship. In the study of Cole(1998), checking account, saving accounts, loans and financial management services are used investigate whether these types of pre-existing relationships affect credit ability and the results demonstrated the incidence of each of the four pre-existing financial services variable are significantly higher for firms extended credit than for firms denied credit.

His research suggested further three the four-saving account, loans and financial management services have a highly significant positive relationship with the probability of receiving a credit. By viewing the figures in Table two of Cole's research, it is found the pre-existing use of a source for especially savings accounts and financial management services increase the likelihood that the lender will extend credit. This might because the savings account provides a guarantee of repayment in some extent and financial management service is usually used by large firms.

The checking account is supposed to be the best resource of monitoring the performance of a firm, but Cole's methodology demonstrated that it is insignificant negative. In addition, the results of that firms extended credit have significantly longer pre-existing relationship with their potential lenders (8.1 vs. 5.5 years) demonstrated the banks prefer firms with longer relationship(Cole, 1998). Backing to the small firm who require credit at the first time in our question, it only has a zero length relationship, which means the potential bank is not available to develop any private information.

A closer examination of the 120 firms with zero length of relationship, which revealed that 47.5%were denied credit as compared to 14.5% of the entire sample, interprets the first time borrower is more likely to be rejected than the firm wants to refinance with its existing lender (Cole, 1998). However, Cole (1998) also proposed that a prospective lender is less likely to extend credit to a firm with demonstrated payment problems. Therefore, the firm who wish to refinance with existing lender is required to have a good record track, otherwise the probability of receiving loan is also low.

Secondly, this bank will investigate public information further. Initially, the bank will examine the firm age, which is used as the proxy of public information by Cole. Diamond( cited in Cole)said the age of the firm should influence the probability of a firm receive credit because firms in business for longer periods of time have established that they can survive the critical start-up period and have generated reputation.

This can be strongly supported by the results of Cole's(1998) research, which shows that firms extended credit is significant older with 16 years old relationship compared to 11 years of denied firms. Indeed, Dunne, Roberts and Samuelson (1989) (cited in Storey) incorporated an age variable into their equation to estimate plant failure rates. They found that, holding size and ownership constant, increasing age was associated with lower failure rates.

Therefore, as a new business, the zero age can not provide adequate proof of its ability to survive and hence the ability to repay. Conversely, that business want to refinance have successfully showed the bank they have survived from the start-up period. Furthermore, bank also study the firm size, which measured by the total assets and total sales or employment size, From the results (Cole, 1998), which showed firms extended credit averaged $3.2 million in assets and $7.0 million in annual sales but firms denied credit averaged $0.8million in assets and $1.5 million in sales, we find that the larger firms have higher probability on applying credit successes.

Dunne, Roberts and Samuelson (1989) (cited in Storey) in their study of US manufacturing plants showed that the average failure rate for the plants with between five and nineteen employs was 104.7 per cent higher than for plants with more than 250 employees. Back to those two firms in question, it is obvious that the existing firm is expected to have higher total asset and sales and more employees than the new and small firm. 

Due to the highly competitive credit market, banks still consider to grant loans to some small and new businesses although the probability is much lower than existing and large firms. In order to reduce the risk, the bank normally requires collaterals in this case.

Cressy and Toivanen (cited in Hanley) found there is a trade-off between the collateral and interest margin using standard regression and 2SLS. Berger and Udell (cited in Hanley) also report a trade-off between collateral and margins for the commitment loans in their sample. Consistent with the descriptive statistics in Hanley's research, the higher the value of collateral provided, the lower the rejection probability, as indicated by the negatively signed coefficient. This result confirms evidence from Basu and Parker (2001) (cited in Hanley) that the main reason of the rejection of application is the lack of security.

Therefore, it is suggest that increasing the collaterals can increase the probability of receiving loans for the small business which require for the first time loan. However, argued by Joseph Stiglitz and Andrew Weiss( cited in Bester), this situation might lead to a problem called adverse selection, which means better borrowers drop out of the applicant pool as the high value collaterals because they have better employment prospects elsewhere at a lower rise and cost and only bad borrowers stay to take gambles.

Despite this, the probability of gaining credit can increase when the firms reduce its required amount of loan. Hanley's (2003) result showed that firms that managed to secure bank finance were more likely to request smaller amounts as evidenced by average amount applied for, 67K and 77k for successful and unsuccessful borrowers respectively. we can conclude that the larger the size of the credit application, the higher the probability that a borrower's application will be rejected by the lender, as evidenced by the positive sign and high significance level for the variable 'borr'(Hanley,2003).