Published on All About Finance

Is relationship-based lending really the second best?

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A woman borrowing money from a friend | © A woman borrowing money from a friend | ©

There is a widespread belief that alternative financing channels that rely on social or business connections are costlier or riskier and that they are used only when asymmetric information and adverse selection cause financing through banks and equity markets to be unavailable. This perspective contradicts several empirical observations: alternative financing remains strong in many economies with developed banks and markets; trade credits are employed more by large or monopoly firms than small firms; and firms that use alternative financing sometimes perform better than those accessing bank loans.

In a recent working paper, we resolve the puzzle by developing a framework that allows competition dynamics among various financing channels in the same funding markets. The study reveals that standard bank financing is not necessarily optimal even when there are no information asymmetry or moral hazard problems. Alternative financing methods are preferred by a range of lenders in the market who have implicit benefits with lenders in transactions. These methods offer lower financing costs and lead to better project outcomes.

Implicit benefits often arise between borrowers and lenders due to social relationships, business connections, repeated interactions, and transactional externalities. For example, corporate insider debtholders have careers and income tied to firm performance. A financial institution providing credits to firms may simultaneously hold the firms' equity. The supplier providing trading credits benefits from the buyer's survival and business expansions. Implicit benefits could also be a reputation concern in repeated games, a spillover effect to other clients, or collateral values associated with social or business relationships.

We use a continuous parameter in the model to subsume a variety of scenarios that correspond to various financing channels with different extents of implicit benefits in real-world practice. These financing channels compete in the same market with no asymmetric information, difficulty in evaluating projects, or capital structure or tax concerns. This approach distinguishes itself from previous studies that approach the topic by demonstrating the desirability of particular alternative channels in coping with specific market imperfections.

Lenders and borrowers aim to maximize their expected utility, respectively, by considering not only their own payoffs in the focal transaction, but also the implicit benefits linked to the other party's payoff from the focal transaction and related investment. Knowing each other's purpose and project conditions, as in a Nash equilibrium, lenders decide on the interest rate and borrowers decide on the level of effort put into the financed project. As a result, in a competitive financing market, although the interest is the same for all financing channels due to funding competition, the borrowers exert greater effort on the project, which leads to better payoffs for both lenders and borrowers. In a monopoly market, although lenders raise the interest rate, they do not reap all the surplus, to induce greater effort from the borrower for the project. This incentive increases with the extent of implicit benefit, leading to rising payoffs to lenders and sometimes borrowers. These results challenge the conventional belief: rather than second best, alternative financing methods, such as family loans, trade credits, and business group financing, are the preferred choice by a range of lenders and borrowers in the market. 

In contrast to the conventional assumption that financing through formal institutions is optimal, bank loans could be the second best alternative among various financing channels. This idea seems counterintuitive to the financial market trend. We enrich the model with project heterogeneity, social-economic dynamics, advantages of financial intermediation, and information networks. These features in the modern economy explain why formal financial institutions like banks become favored, despite the advantages of other financing methods in the general setting.  For example, when project size and complexity expand, specialized expertise and large funding pools in financial institutions become essential. The implicit benefits arising from social networks and repeated games shrink when community mobility increases in modern society.

We also use continuous parameters to subsume varieties associated with enforcement costs in repayment and nonpecuniary penalty in addition to implicit benefit. These costs could be the threat of bankruptcy or the consequences associated with bank loan default, social sanctions, and enforcement difficulties. Including these dimensions allows us to understand how institutional or legal environments affect competition among financing channels. For example, repayment cost increases in countries with weak legal systems; lenders and borrowers who access political, social, or other networks to reduce this cost or increase implicit benefits dominate the market. This finding explains why power arrangements, namely kinship, state control, or legality, are critical for a country's financing and growth pattern.

Our findings in this study have important implications for the outlook of the financial industry trend and corresponding policy making. First, financing channels like trade credits, business group lending, insider debt, and joint ownership of debt and equity, among others, will continue to expand as they offer improvements over conventional bank financing. Second, the size of the improvement is related to the extent of implicit benefits and repayment costs. They differ across industry structure, ownership pattern, legal system, financial market condition, culture, and so forth. Therefore, one style is unlikely to fit all, although the same generic mechanism drives them. This consideration is critical in policy making for developing regulations, planning the structure of the economy, or providing funding aids. Finally, the benefit of fintech lending depends on whether the application of technology effectively utilizes the advantage of implicit benefits or reduction of repayment costs, in addition to improving information efficiency. This insight is critical for developing regulation guidelines for the rising fintech industry. 



Franklin Allen

Professor of Finance and Economics, Director, Brevan Howard Centre, Vice-Dean of Research and Faculty of the Business School, Imperial College

Meijun Qian

Professor of Finance, Academic Dean, Zhejiang University International Business School

Jing Xie

Assistant professor of finance, Hong Kong Polytechnic University

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