Why Small Banks Aren't Always Best for Small Business Loans

Despite conventional wisdom, a new study shows that small banks aren't always the best option when looking for a small business loan.

Researchers at Harvard and Yale universities found that local banks, which are thought to be best for small businesses because their decentralized lending structure gives branch managers autonomy over lending decisions, only are the best option for financing small businesses if they face local competition.

"We show that it is true that decentralized banks create better lending outcomes for small firms than centralized banks, precisely because of the discretion granted to local branch managers," said researcher Rodrigo Canales of the Yale School of Management. "The huge caveat is that this is only true when there’s competition."

According to the study, without competition, the same discretion that branch managers have shaping lending decisions to the local environment also allows them to exploit their power by cherry-picking the best firms, approving smaller loans and charging higher interest rates.

"If the decentralized bank is the only game in town, the manager will give firms worse conditions because he or she knows the firms don’t have other options," Canales said. "If there is competition, the manager can react to that and operate in ways that centralized competitors cannot."

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The study's authors said the results help explain why entrepreneurship increased following the U.S. banking deregulation that decreased the number of small banks.

"You would expect that lending to small firms would have dropped when banks were able to become centralized and nationalized," Canales said. "The increase in lending to small businesses may have occurred because small banks no longer had local monopolies, and the addition of market competition benefited entrepreneurs."

The research has implications for how to help small businesses, according to Canales.

"If you want to help small firms, then you want to foster competition, and you want to foster a variety of lending models instead of just focusing on centralized or decentralized lending for small business," he said.

The study, which was co-authored by Ramana Nanda of Harvard Business School, was published in the August issue of the Journal of Financial Economics.

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