When arm’s length is too far: relationship banking over the business cycle

Share this page:

Following the global financial crisis, policy-makers’ attention has focused on lending to SMEs, as these were among the most affected when the credit cycle turned. Governments have introduced various measures that may alleviate short-term funding constraints but are unlikely to be a long-term solution. So is there a way to protect entrepreneurs in a more structural way from the cyclicality of credit?

In this Working Paper Ralph De Haas, EBRD; Thorsten Beck, Cass Business School; Hans Degryse, KU Leuven; and Neeltje van Horen, De Nederlandsche Bank, analyse how banks’ lending techniques affect funding to SMEs over the business cycle.

They differentiate between relationship and transaction lending and find that while there is little difference between these two techniques during good times, it is relationship lending – whereby banks develop long-term relationships with firms to get to know them well – that is the more effective way to lend during cyclical downturns.

The results show that firms that are surrounded by branches of banks that put a lot of emphasis on getting to know their customers, have easier access to credit compared with firms that have to rely on banks that take a more arms’ length approach and place less emphasis on borrower due diligence.

These findings suggest that the ability of banks to continue to lend during a crisis, when uncertainty about borrowers’ prospects increases, not only depends on banks’ own access to funding but also on their ability to adequately screen potential clients.

Read the Working Paper in full (1MB - PDF)

Share this page: