Research proposal

University of Surrey

School of Management

Effects of bank debt relationships on corporate performance

by

W. Ziemer

Submitted in part fulfilment of the requirements for the degree of Doctor of Business

Administration

July 2015

Abstract

Effects of bank debt relationships on corporate performance is an empirical survey based on a unique recent dataset regarding German manufacturing firms for the years 20032010. It seeks to understand the opportunities for German banks to offer services solely linked to information generated within loan-monitoring processes, relaxing the common assumption that banks are informationally disadvantaged because credit markets do not perfectly equalize in prices but in the bank-optimal rate; the existence of red-lining and rationing demonstrates credit markets informational imperfection. The flow of information in credit markets is basically one way, and banks improve their abilities to distinguish borrowers to prevent related losses. Therefore, they are able to generate new information that is then used for further borrower evaluation.

This newly generated information is assumed to be superior to borrowers knowledge, and borrowers might recognize and anticipate this information. Therefore, the informational chain evolves into the proposed theory of the customer-improving loan-monitoring cycle. It is assumed to be true if borrowers with bank debt show better results than borrowers without. Related hypotheses regarding corporate performance preferably are tested by using return on equity. Additionally, net operating margin, net interest, and return on investment are checked for their patterns. They are supplemented by sustainability tests regarding the equity-to-debt ratio and the distance-to-default point to evaluate whether positive effects are based on chance or opportunistic behaviour.

All performance hypotheses are rejected. Therefore, the proposed theory does not find support from the evidence, and banks informational disadvantage remains even if their borrower evaluation is actually more detailed than before. Accordingly, the survey shows that loan monitoring does not offer informational links to generate new products or services, and banks remain limited to their already applied approaches. German corporate performance is basically convexly associated with firm size, and firm performance clearly differs depending on firms riskiness. However, risky firms results are superior if they report bank debt because banks related monitoring generates moderating effects. Thus, particularly risky firms are suggested to use bank debt.

Declaration of originality

I declare that my thesis entitled Effects of bank debt relationships on corporate performance and the work to which it refers are the results of my own efforts. Any ideas, data, images, or text resulting from the work of others (whether published or unpublished) are fully identified as such within the work and attributed to their originator in the text or bibliography. This thesis has not been submitted in whole or in part for any other academic degree or professional qualification. I agree that the University has the right to submit my work to the plagiarism-detection service TurnitinUK for originality checks. Whether or not drafts have been so-assessed, the University reserves the right to require an electronic version of the final document (as submitted) for assessment as above.

Signature:

Wolfgang Ziemer

Date: 7th July 2015

Table of contents

Abstractii

Declaration of originalityiii

Table of contentsiv

List of figuresviii

List of tablesix

Acknowledgementsxi

Abbreviationsii

Glossaryiv

1Introduction1

2Philosophical stance5

3Literature7

3.1Nature of corporate banking7

3.1.1Corporate banking7

3.1.2Pricing8

3.1.3Nature of banking11

3.1.3.1Uncertainty11

3.1.3.2Avoidance strategies11

3.1.3.3Boundaries of Akerlofs (1970) model13

3.1.3.4Positioning strategies14

3.1.3.5Steady-state markets17

3.1.3.6Corporate banking service markets17

3.1.4Credit markets19

3.1.4.1Informational problems19

3.1.4.2Red-lining20

3.1.4.3Credit rationing21

3.1.4.3.1Rationing as rational behaviour21

3.1.4.3.2Market equilibrium22

3.1.4.3.3Bank-optimal interest rates24

3.1.4.4Investment problems25

3.1.4.5Collateral25

3.1.4.6The credit markets informational situation27

3.1.5Information on customer levels28

3.1.5.1Agency theory28

3.1.5.2Agency problems29

3.1.5.3Appropriate behaviour30

3.1.5.4Agency costs and values32

3.1.5.5Informational situation regarding agents36

3.1.6Informational level38

3.1.6.1Banks as information factories38

3.1.6.2Information collection39

3.1.6.2.1Sources39

3.1.6.2.2Banks loan evaluation40

3.1.6.3Information assessment42

3.1.6.3.1Recognition and evaluation42

3.1.6.3.2Internal ratings43

3.1.6.4Information production44

3.1.6.4.1Banks generate new information44

3.1.6.4.2Systematic information generation46

3.1.6.5Summary regarding information48

3.1.7Empirical research50

3.1.7.1Independent variables50

3.1.7.2Dependent variables55

3.1.7.3Relevant results57

3.2Distinctive characteristics of the German banking-market59

3.2.1The German housebank system59

3.2.2The impact of the second Basle accord on German banks policy61

3.2.3Impact of the subprime crisis on German firms financing62

4Hypothesis development64

4.1External monitoring services64

4.2Possibility of banks informational advantage66

4.3The loan-monitoring cycle67

4.4Missing evidence for informational states71

4.5Hypothesis development and predictions71

4.6Framework74

5Data77

5.1Outcome variables77

5.1.1Performance measures77

5.1.1.1Return on equity77

5.1.1.2Net interest78

5.1.1.3Net operating margin78

5.1.1.4Return on investment79

5.1.2Sustainability measures80

5.1.2.1Equity-to-debt ratio80

5.1.2.2Distance-to-default parameter80

5.2Relationship and control variables81

5.2.1Relationship variables81

5.2.2Other covariates83

5.3Sampling strategy85

5.4Data collection87

5.4.1Non-random sampling87

5.4.2Data collection procedures90

5.5Preliminary data screening93

5.5.1Upload and visual screening93

5.5.2Preliminary test strategy95

5.5.3Data description99

5.5.4Pre-test analysis103

5.5.5Pre-test measure comparison110

6Methodology and empirical analysis114

6.1Methodology114

6.1.1Comparisons and models114

6.1.2Expected low levels of R117

6.2Empirical analysis118

6.2.1Grouping criteria118

6.2.2Return on equity121

6.2.2.1Fundamental analysis of return on equity121

6.2.2.2Return on equitys regression on bank types125

6.2.2.3Effects of bank types on return on equity127

6.2.2.4Extreme values of return on equity128

6.2.2.5Return on equity according to total assets and liquidation value130

6.2.3Additional measures137

6.2.3.1Fundamental analysis of additional measures137

6.2.3.2Extreme values of additional measures141

6.2.3.3Additional measures for total assets and liquidation value143

6.2.4Sustainability and robustness tests148

6.2.4.1Equity-to-debt ratio and distance-to-default parameter148

6.2.4.2Extreme values of EtDR and DtDP153

6.2.4.3The effects of total assets and liquidation values155

6.2.4.3.1Effects on the equity-to-debt ratio155

6.2.4.3.2Effects on the distance-to-default parameter160

6.2.4.4Effects of economic conditions163

6.2.5Summary of the empirical analysis164

6.2.5.1General pattern164

6.2.5.2Results regarding return on equity165

6.2.5.3Results regarding the additional measures167

6.2.5.4Sustainability and robustness170

7Judgements about hypotheses and theory172

7.1Hypotheses172

7.2Theory175

8Conclusions177

9Reflective chapter182

References192

Annex214

List of figures

Figure 1: Corporate banking product classification7

Figure 2: Qualityprice association in markets that are efficient in terms of information9

Figure 3: Flow of information10

Figure 4: Rip-offs and lemon markets price associations12

Figure 5: Market outcome for informational asymmetry13

Figure 6: Prices association with reputation formation16

Figure 7: Red-lining21

Figure 8: Red-lining and credit rationing24

Figure 9: Agency model29

Figure 10: Monitoring activities of banks38

Figure 11: Banks informational processes50

Figure 12: Informational chain68

Figure 13: Loan-monitoring cycle70

Figure 14: Time horizon85

Figure 15: Database decision87

Figure 16: Missing information about firms bank relationship types93

Figure 17: Preliminary test strategy96

Figure 18: Histograms for raw data98

Figure 19: Scatterplots106

Figure 20: ROE regression for independent variables108

Figure 21: ROE according to total assets percentiles132

Figure 22: ROE means for non-negative liquidation values135

Figure 23: ROE means for negative liquidation values135

Figure 24: EtDRs means according to non-negative liquidation values157

Figure 25: EtDRs means according to negative liquidation values158

Figure 26: All additional performance measures relation to firm's equity168

Figure 27: Epistemological loops189

List of tables

Table 1: Market strategies for services17

Table 2: Examples for market strategies in banking18

Table 3: Independent variables used in research51

Table 4: Dependent variables used in research56

Table 5: Empirical survey results58

Table 6: Classification of 267 HGB84

Table 7: Table of variables85

Table 8: Dafne Neos report87

Table 9: Assignment of bank types92

Table 10: Samples growth pattern95

Table 11: Data Description100

Table 12: Correlation Matrix102

Table 13: Pre-test analysis104

Table 14: Measures percentages of observations within their standard deviations110

Table 15: Performance measures comparison111

Table 16: Means for independent variables113

Table 17: ROE OLS regression for all firms and all variables120

Table 18: ROE description121

Table 19: T-tests for ROE121

Table 20: ROE OLS regressions122

Table 21: Total assets means for binary bank types125

Table 22: ROE regression on binary grouped firms bank types126

Table 23: ROE comparison for binary bank types127

Table 24: ROEs excluded items128

Table 25: ROE for continuous variables different values131

Table 26: Groups ROE according to total assets percentiles133

Table 27: ROE t-tests and adjusted Wald tests134

Table 28: ROE regression differentiated according to liquidation value136

Table 29: The other performance measures descriptions137

Table 30: Regression of additional variables139

Table 31: Group comparison for additional variables140

Table 32: Net operating margins excluded items142

Table 33: ROIs excluded items143

Table 34: Net interests excluded items143

Table 35: Groups net operating margins according to total assets percentiles145

Table 36: Groups returns on investment according to total assets percentiles146

Table 37: Groups net interest according to total assets percentiles147

Table 38: EtDR and DtDPs descriptions148

Table 39: Delimited regressions of EtDR and DtDP150

Table 40: Group comparison for EtDR and DtDP153

Table 41: EtDRs excluded items154

Table 42: DtDPs excluded items155

Table 43: Groups EtDR values according to total assets percentiles156

Table 44: EtDRs regression differentiated according to liquidation values159

Table 45: Groups DtDP values according to total assets percentiles161

Table 46: DtDPs regression differentiated according to liquidation value162

Table 47: ROE's regression regarding economic conditions163

Annex Table 1: Histogram of ROE for raw data214

Annex Table 2: Histogram of ROE after Cook's distance214

Annex Table 3: Histogram of ROE after dfbeta214

Annex Table 4: Histogram of NetOpMargin for raw data215

Annex Table 5: Histogram of NetOpMargin after Cook's distance215

Annex Table 6: Histogram of NetOpMargin after dfbeta215

Annex Table 7: Histogram of NetInterest for raw data216

Annex Table 8: Histogram of NetInterest after Cook's distance216

Annex Table 9: Histogram of NetInterest after dfbeta216

Annex Table 10: Histogram of ROI for raw data217

Annex Table 11: Histogram of ROI after Cook's distance217

Annex Table 12: Histogram of ROI after dfbeta217

Annex Table 13: Histogram of EtDR for raw data218

Annex Table 14: Histogram of EtDR after Cook's distance218

Annex Table 15: Histogram of EtDR after dfbeta218

Annex Table 16: Histogram of DtDP for raw data219

Annex Table 17: Histogram of DtDP after Cook's distance219

Annex Table 18: Histogram of DtDP after dfbeta219

Acknowledgements

Special thanks to my supervisors Prof. Sarmistha Pal, Prof. Frank Skinner, Dr Liang Han, and Dr Sam Agyei-Ampomah for their support, patience, motivation, and valuable comments. They have all considerably contributed to my progress. Prof. David Gilbert enabled us to sharpen our ideas in the first core modules. Dr Julie Gore recognized my methodological problem and arranged a chat with Dr Julinda Nouri, who was able to mitigate the issue. I acknowledge the participants of the University of Surreys Annual Finance PhD Workshop 2014 for their interesting discussions and gratefully mention Jane Cook and Beatrice Spedicato for their background activities. I also gratefully acknowledge Prof. Volker Oppitz, who guided me regarding asymmetric information. Finally, I would like express my thanks to my wife Susanne, who allowed me to undertake this project and accepted a lot of time without me.

iv

Abbreviations

ABS

Association of Business Schools

AG

stock corporation (public company limited by shares)

al.

Latin: alii (masculine) or aliae (feminine); translated: others

BvD

Dutch: Bureau van Dijk

CFO

chief financial officer

DBA

Doctor of Business Administration

DepVar

dependent variable

EBIT

earnings before interest and taxes

EBITDA

earnings before interest, taxes, depreciation and goodwill amortization

edn.

edition

ed.

editor

eds.

editors

e.g.

example given

GAAP

Generally accepted accounting principles

GmbH

Limited liability company

H

hypothesis

HGB

Handelsgesetzbuch (German Trade Law)

IKB

IKB Deutsche Industriebank AG, Dsseldorf, Germany

ISIN

International securities identification number

KWG

Kreditwesengesetz (German Banking Regulation Law)

ln

natural logarithm

log

logarithm

No.

number

NPV

net price value

n.v.

not available (no value)

OLS

ordinary least squares

P

proposition

p.

page

p/l

profit and loss

p.m.

post meridian

pp.

pages

Prof.

Professor

resp.

respectively

TOEFL

test of English as a foreign language

UK

United Kingdom

USA

United States of America

USD

United States Dollar

vs.

versus

Glossary

IKB

Germanys leading bank in financing small- and medium-sized entities, with a strong focus on credit business

net income

total result of a firms reported annual profit and loss account

1. Introduction

The observed outcome of German banks business regarding fee and commission income is generally unsatisfactory. IKBs results do not entirely differ from this pattern. Despite several attempts, IKB has not been able to expand its credit business successfully by additional services or products. For instance, its net fee and commission income for the business year from 1st April, 2009 to 31st March, 2010 amounts only to 24.8 million euros for its lending business and 1.8 million euros for securitization, while there is no considerable other income reported (IKB Group, 2010). A comparison with German competitors reveals that this is a general pattern across the whole sector. However, the other banks earn additional commission fees through payment services or the brokerage and administration of securities (Commerzbank Group, 2009; WGZ, 2009). In contrast, IKB is strategically self-restricted to credit-related business and does not offer these services. Therefore, IKB does not possess these anchors to additional turnover, and its generation of additional fee and commission income depends necessarily on different approaches. Thus, the overriding aim of this study is to look for opportunities for additional services or products solely linked to credit business, but this is opposed by the sector-wide pattern. Accordingly, the following general research question is surveyed: How can durable additional services or products be linked solely to the information distributed internally between lenders and borrowers?

Basically, this question leads to an analysis of the effects of the informational relationships between borrowers and banks as direct lenders. It presumes that banks have some informational advantage to borrowers that they can use to generate additional services or products. Unfortunately, it is commonly assumed that borrowers are better informed about their projects than lending banks are. However, observation of a phone chat between IKBs former CFO and a rating agency suddenly created the idea that the banks borrowers would not be able to argue in the same manner. Accordingly, this observation has cast doubt on the common assumption and initiated the first idea that IKB may be able to offer some consulting services to hitherto not monitored prospective customers. If IKB acquired superior knowledge to borrowers information in its loan business, a possible link would exist.

From a positivist stance, being successful requires actions to be taken in accordance with the natural order that Comte (1844) defines as the result of the totality of connected event laws. Regarding business, these rules are subject to economics. The phenomenon of asymmetric information exists a priori, and all business action derives from informational deficiencies (Ricketts, 2002). Use of knowledge and the allocation and exchange of resources are economic activities and, therefore, subject to asymmetric information (Hayek, 1945). Regarding credit markets, new institutional economics analyses informational deficiencies mainly related to uncertainty about the expected quality of the borrower. Within a situation of decision making and imperfect information, the rational agent is assumed and related problems are examined (Simon, 1959).

It is generally assumed that borrowers are better informed about their financed project than lenders are. However, this assumption has been neither exactly defined nor empirically proven. Following de Meza and Southey (1996), this assumption is relaxed because banks can refer to huge collections of knowledge about their customers. Moreover, they pose that borrowers are likely to be overoptimistic and do not properly evaluate their own riskiness. Similarly, Hillier and Ibrahimo (1993) state that reversing this assumption may be worthwhile because this could deliver additional explanations. This view is supported by Degryse and Ongena (2005), who find that price discrimination on the Belgian credit market occurs for transportation costs but not for asymmetric information. Moreover, in 2010, the German Provincial High Court in Stuttgart accepted that banks are better informed than their customers in some respects (Roberts, 2010b). Even if this jurisdiction does not make judgements about the informational relationship between banks and customers, it was the first time that a German court had acknowledged this information difference. However, the contemporary theory neither offers evidence for the assumed informational stance on credit markets nor sufficient analyses of the relationships effects on the borrowing firms performance. Therefore, the present study contributes to the academic literature firstly by generating evidence for informational stances on credit markets and secondly by exploring the effects of bank loan relationships on the overall performance of German firms.

Literature about financing is characterized by a theoretical lead, while banking literature is closer to practice, and they do not create a common view (Terberger, 1987). Literature about banking mainly explains the types and features of instruments in detail from a practitioners stance and creates recommendations on how to act but does not assume unconditioned fulfilment. In contrast, literature about financing abstracts from theoretical cash-flows. The previous surveys theoretical setting tried to bridge the gulf between both lines of theory by the use of Comtes idea. The setting considered the natural orders different levels and related literature about financing to its higher and literature about banking to lower levels. However, this survey sought to understand the general patterns in the loan business. It did not intend to analyse single contracts to find new possibilities of additional services. This issue can actually be addressed by banks because it refers to financial engineering and covers the already existing approaches of banks. For instance, when customers need loans in foreign currencies, banks offer both loans in foreign currencies and currency-exchange services.

The course of this work starts with consideration of the natural orders higher levels and contrasts new institutional economics mechanisms of primary good markets and credit markets. In the first step, the nature of products and services is analysed to create an informational foundation of prospective services linked directly to credit-related informational stances. It shows that new services need a position strategy and should be supported by banks existing reputation. Secondly, a closer examination of credit markets triangulates informational processes in the loan business and demonstrates that credit markets do not perfectly equalize in prices but in the bank-optimal interest rate. Moreover, the existence of red-lining and rationing demonstrates that credit markets are imperfect in terms of information. Then, agency theory as a description of the single relationship between banks and borrowers is considered to identify the informational problems with loan relationships. Basically, borrowers are only interested in getting the desired amount, while banks suffer from loan contracts risk transfers. Accordingly, banks address their informational problems but borrowers do not. Subsequently, informational patterns and processes are investigated. They depict an informational chain that describes one-way directed information transmission. Borrowers reveal information but banks accumulate and analyse it. Moreover, banks generate new information, which may be superior, and use it in their monitoring activities. It is inferred that firms may learn from banks improved monitoring abilities and may thus increase their performance measures for such monitoring. Therefore, the theory of the customer-improving loan-monitoring cycle is posed. Finally, this theory is tested by hypotheses that cover its assumptions.

Unfortunately, empirical research regarding the effects of the relationship between banks and borrowers on firm performance is sparse. Basically, most of the existing literature examines the effects on a single instruments conditions or the effects on bank performance. Moreover, no common convention regarding the relationships measurement exists. Therefore, it was decided to deploy the measures and covariates used by the majority of researchers and to supplement them with additional hitherto disregarded variables. Finally, the effects are measured by firms return on equity. The alternative measures of net operating income, return on investment, and net interests are widely ignored because they appear to be problematic. Additionally, the results sustainability and the firms robustness are analysed based on the equity-to-debt ratio and the distance-to-default parameter.

The present survey is based on a unique sample of German manufacturing firms for the years 2003 up to 2010. These years cover the first period after the second Basel Accord was incorporated. Accordingly, the empirical analysis examines whether the related enlargement of banks loan evaluation may reverse informational stances on credit markets. Unfortunately, the sample is characterized by unimodal variables of high kurtosis with long and flat arms. Thus, the empirical analysis suffers from extremely low significance levels. Moreover, the datas nature generates particular difficulty in that individual outliers can hardly be detected. Therefore, automatic procedures using dfbeta for outlier detection and elimination are deployed. However, these automatisms remain insufficient. Accordingly, the analysis is divided into the examination of dependent variables within their standard deviation, with additional consideration of observations outside their standard deviation.

Finally, the hypotheses regarding the posed theorys assumptions are rejected. Therefore, the posed theory could not be at least partially verified because the empirical analytical results only in some marginal and insignificant way indicate possible links for additional services. The analysis demonstrates that banks remain disadvantaged despite their more detailed borrower evaluation and loan monitoring. Accordingly, the loan business does not offer possible informational links to generate additional services oder products.

1. Philosophical stance

Researchers need a vision of realitys nature and a clear understanding about knowledge generations legitimization (Girod-Sville and Perret, 2001). If they assume reality to exist independently from mankinds being and perception, they can objectively observe it and discover its mechanisms (Giorgi, 2002; Saunders et al., 2009). Otherwise, they can subjectively interpret or construct its concepts. Their assumption also defines the tension between empiricism and rationalism. Each stance requires its own methodology and poses unique questions. Its choice determines the whole research project (Royer and Zarlowski, 2001). Accordingly, researchers need to relate their way of thinking, the research paradigm, and their philosophy on their subject. They need clear aims and should be able to discuss their philosophys strengths, weaknesses, and uses (Chia, 2002).

My research looks for new approaches to generate additional fee income solely linked to the banks information that is newly generated by interactions within loan relationships. Basically, this contradicts the common assumption that lending banks are informationally disadvantaged in comparison to their borrowers. Therefore, interpretative, constructive, and subjective approaches are inappropriate because I need to falsify this view. Accordingly, positivism is appropriate for my research because it requires objective observation. However, knowledge generation can be based on different philosophies. Therefore, my literature review is pragmatically not limited by previously published works philosophical underpinnings. Nevertheless, my work beyond the literature is strictly based on sceptically rationalized positivism to avoid problems related to pure positivism (Popper, 2005).

I entirely rely on Comtes (1844) vision that reality ruled by the natural order exists independently. It sanctions every action perceived by actors as positive or negative experiences. The natural order consists of levels with different grades of opaqueness. Regarding my research project, the known levels are general markets, credit markets, the individual relationship between lender and borrower, and the informational distribution between them. Its mechanisms are assumed to affect them inherently from the most general level to the lower levels, mainly for their tendency to equalize. Therefore, I follow existing knowledge regarding these levels to understand their mechanisms and to discover imperfections, assuming that they offer clues for desired links. Nevertheless, the natural order ultimately remains opaque. It can only be indirectly observed in visible reactions outside its being.

Ontologically, I follow realism and accept that both an observable reality and an unobservable reality exist. However, the unobservable realitys existence is taken for granted because it and its objects are named (Schlick, 1932). Nevertheless, in accordance with the positivist tradition, knowledge generation regarding the unobservable world is epistemologically denied. It simply cannot be the subject of positivist research. Following this reasoning, knowledge generation needs positively observable evidence (Schlick, 1959). However, pure positivist approaches remain insufficient. Therefore, they are sceptically rationalized (Popper, 2005).

Examining the literature shows that reality regarding my research subject does not perfectly equalize. Based on this insight and a small piece of induction, I deductively pose a theory (Mill, 1846). It hypothesizes the natural orders effects by a reduced model and offers a quasi-causal mechanism (Sloane, 1945). Hypotheses regarding its assumptions are tested by accounting data to verify or falsify them empirically. However, testing cannot simply look for evidence but also needs significance because insignificant changes may be caused by researchs imperfections. In turn, insignificant evidence may not definitively falsify the theory. Nevertheless, the theory is believed to be true according to the deployed tests evidence.

My data represents a sufficiently great sample of externally published accounting data based on the positivist German Trade Law. Therefore, it is reliable and the required validity can be achieved by the rigorous application of method or techniques (Rolfe, 2006, p. 305). Basically, this refers to statistical conclusion validity, internal validity, construct validity, and external validity (Calder et al., 1982). Accordingly, I deal very carefully with my data, base my judgements only on statistically significant results, and rationalize all results sceptically. Nevertheless, my work remains biased regarding sample survivorship, but this is justified because my theory requires the observation of surviving firms (Kruglanski and Ajzen, 1983).

1. LiteratureNature of corporate bankingCorporate banking

Approaching banks lack of success in gaining net fee and commission income from the view that the natural order could be violated poses a question regarding how markets for different banking products work. Thus, corporate banking is introduced to imagine its different mechanisms. Figure 1 presents Schierenbecks (1993) corporate banking product classification. He differentiates commercial and investment banking, supplemented by the non-banking product of insurance. According to his categories, commercial banking contains short- and long-range deposits, loans of different durations or uses, and payment services. Investment banking in its narrow sense means commission-based services like securities; in its broad sense, it means special transactions of a one-off character (e.g. mergers and acquisitions, financial innovations, and foreign exchanges).

Figure 1: Corporate banking product classification

Most banking services consist of a pure technical component and an added-value consulting component (Juncker, 1993). Basic services like accounts and payments require branch-wide standardization because they need uniform functionality (Hartmann, 1993; Schmidt-Chiari, 1993; Terrahe and Schuck, 1993). Consulting is a complementary service preferably arranged with specialized consultants because of its complexity (Berger, 1993). However, financial consulting regarding currency, interest, and liquidity risks or asset management are banks core competences (Leber and Wrtenberg, 1993; Wertschulte, 1993). Additionally, their early risk-recognition systems and predictions of borrowers credit quality are well established (Reuter, 1993).

Additional turnover in corporate banking relies on increasing transaction numbers and values or product innovations (Schierenbeck, 1993). Both can be promoted either with mass customization or sales initiatives (Klenk et al., 2009). However, pricing in corporate banking is difficult and often related to the total yield of a relationship, which requires sufficient transparency regarding both sides utility (Dolff and Tober, 1993; Klenk et al., 2009). However, different arguments about financial instruments effects remain because of their complexity and different market positions.

Corporate customers expect confidence, accuracy, speed, flexibility, and good conditions; however, in these areas, banks are highly competitive. Therefore, banks need to generate surplus value to build up their own success (Htzel, 1993). Nevertheless, banks appear to be homogeneous because of their similar service profiles (Ludwig, 1993). Additionally, German corporate customers are used to having two to four durable bank connections of likely more than 25 years (Duttenhfer and Keller, 2004). They are not locked into these relationships but change them only for urgent reasons, as they represent valuable assets (Ongena and Smith, 2001). For instance, they provide some kind of liquidity insurance (Elsas and Krahnen, 1998). Additionally, long-lasting relationships facilitate monitoring and screening (Boot, 2000). This creates a situation of relationship pricing where banks basic services are often unprofitable because they are used as anchors to link further services (Brost et al., 2008). Nevertheless, achieving of consulting honoraries is not very successful in Germany unless it is directly linked to an accepted basic service (Schrder, 1997; Severdit, 2001).

However, the idea of relationship pricing opposes neoclassical theory because these prices are not based on a single products quality or utility. This poses a question regarding which mechanisms rule the markets for corporate banking.

Pricing

Markets, as information-presuming institutions, coordinate the decentralized decisions of many individual subjects. Information on markets is imperfect because it is costly; if it is not costly, perfect information leads to market breakdown (Grossman and Stiglitz, 1980). Accordingly, markets are imperfect, and this results in consequences regarding market participants behaviour. Informational asymmetry arises because the total utilization of knowledge is not similarly possible to everyone (Hayek, 1945). Accordingly, markets are concerned with uncertainty about quality, facing the problem that information is only transferable to a limit (Hirshleifer, 1973).

Classical economics assumes the price system contains and delivers all relevant information efficiently and determines agents rational behaviour (Grossmann and Stiglitz, 1976; Hayek, 1945). Figure 2 depicts the rational priceinformation association, where qualitys equalization represents the grade of quality uncertainty. The concept of equilibrium explains the fact that efficient markets are cleared by accepted errors inexactly equalizing prices based on the related quality expected by buyers demand and sellers offers (Holt, 1996; Shapiro, 1983). Therefore, markets are indirectly cleared by information about the underlying quality and remain efficient if this association yields similar levels.

Figure 2: Qualityprice association in markets that are efficient in terms of information

However, quality uncertainty remains because quality is multidimensional, hardly quantifiable, and contains subjective elements; additionally, the claimed offered quality is seriously questionable (Hirshleifer, 1973). Thus, neoclassical theory cannot appropriately describe markets because information costs lead to price dispersion, which does not achieve equilibrium (Salop and Stiglitz, 1982). Prices generally only reflect available information and the price systems effectiveness and therefore depend on the number of informed individuals (Grossman and Stiglitz, 1980). Accordingly, paid prices are not merely the result of rational behaviour but also of good luck regarding knowledge about prices or quality. This leads to non-competitively equilibrated markets and poses three serious problems.

Firstly, quality uncertainty is conceptually described as noise. The behaviour or characteristics of one contract partner are unchangeable, but the other partner only becomes aware ex-post because information or characteristics are hidden (Stigler, 1961; Hartmann-Wendels, 1989; Kiener, 1990). Therefore, quality uncertainty is related to adverse selection. Accordingly, market activity declines with uncertaintys magnitude (Batra and Russel, 1974).

Secondly, holdup conceptually describes the sunk costs for irreversible commitments (Alchian and Woodward, 1988; Breid, 1995). It characterizes the hidden intentions of one contract partner, which are also only visibly ex-post. Gaps in contracts are opportunistically used as room for interpretation, which opens hidden possibilities to one contract partner. Holdup is not necessarily created by opportunistic behaviour; it also appears due to a lack of communication between contract partners or due to the development of the surroundings of one partner. Therefore, holdup is associated with authority and hierarchy in contracts, but it is impossible to set out perfect conditions because partners may fail by chance.

Thirdly, moral hazard is the concept of uncertainty for plasticity and means an agents discrete room to act opportunistically (Alchian and Woodward, 1988). Plasticity is the magnitude of resources that can be interchanged. It describes deliberate behaviour remaining hidden ex-post because an agents observation is either impossible or prohibitively costly (Holmstrm, 1979, p. 74). It is characterized as contractual relationships inability to allocate risks effectively in risk-spreading contracts (Marshall, 1976). Accordingly, its salvation is mainly related to result-sharing incentive systems.

Figure 3: Flow of information

To overcome these problems, the trustworthy transmission of valuable information is necessary (Spence, 1973). Figure 3 depicts this flow of information characterized by activity (Spence, 1973; Kaas, 1991). Screening describes the information procuring of informationally disadvantaged actors, while signalling refers to the information transmission of better-informed participants. Screeners and signallers economically try to use devices and mechanisms because they have to bear related costs (Riley, 1976). Formerly, screening and signalling were treated as indirect transfer mechanisms, but nowadays they are also treated as direct transmission (Kaas, 1991). Signalling and screening between cooperating parties not only characterize deliberate information transmission but also reveal misleading or concealed information.

Nature of bankingUncertainty

The following chapters generate an understanding about how the markets for corporate banking services are ruled. It is visualized that market participants use several strategies to prevent themselves from the problems of asymmetric information.

As all good markets are, the markets for corporate banking services are primary markets characterized by the direct exchange of services and money. Sellers guarantee minimum service quality by civil law. Substantially, these services are agency relationships with banks as agents and customers as principals, where service quality is hidden a priori (Dejong et al., 1985b). In his important article The Market for Lemons [...], Akerlof (1970) relates quality and uncertainty. Since its publication, a considerable amount of research has surveyed markets under conditions of asymmetric information. Market formations are sensitive to the market institutional framework and the prevailing information condition (Wilson and Zillante, 2010, p. 15). They can be categorized into three basic informational market states: unsolvable asymmetric information, serious asymmetric information, and steady-state informational symmetry. Market participants deploy different strategies in the face of these. The elimination of informational asymmetry seems to be the best remedy, but it is often impossible or too expensive (Leland, 1979). Moreover, Levin (2001) demonstrates that better information does not necessarily improve market activity.

Avoidance strategies

If the issue of asymmetric information is unsolvable, the strategy of market participants is to avoid suffering. Assuming that market statistics are used to substitute missing information, Akerlof (1970) demonstrates that asymmetric information may lead to the lemon market outcome of market reduction (see also: Leland, 1979; Wilson and Zillante, 2010). He observes an enormous price difference between new and just-bought cars and describes a primary good market for used cars where sellers have the informational advantage over buyers because of their experienced knowledge (Akerlof, 1970; Emons and Sheldon, 2009). The quality of used cars is exogenously given and can only be changed within limits (Shapiro, 1983). Lemon markets are characterized both by buyers willingness to pay only average prices for their expectation of average quality and by sellers who do not want to sell above-average quality at average prices. Therefore, despite quality differences, sales need to have the same prices. Akerlof (1970) associates prices and quality. The particular problem is the purchasers difficulty in identifying quality. If buyers recognize that they will not obtain appropriate quality, they will only expect minimum quality and will pay less (Klein and Leffler, 1981). Thus, a moral hazard problem arises because high quality is not sold for average prices but minor quality is. In other words, bad quality may drive out good quality. Subsequently, market activities decrease for adverse selection because reliable information is missed (Grossman and Stiglitz, 1980).

Figure 4: Rip-offs and lemon markets price associations

Figure 4 depicts the affected price association in lemon markets. Buyers expect better quality than delivered but are not able to identify worse quality ex-ante. Thus, they pay more than they would be willing to if they knew the real quality. Akerlof (1970) explains that potential buyers of high quality will withdraw from the market when they ex-post recognize this situation. A simple explanation is that buyers shift their demand and substitute their needs with other goods (Kim, 1985). Subsequently, market activity declines for buyers self-protection (Holt and Sherman, 1999). Market withdrawal has been confirmed by classroom games regarding unspecified goods in a lemon market setting (Holt and Sherman, 1999; Wolf and Myerscough, 2007). It represents market participants ultimate and final avoidance strategy, which may end up in market breakdown due to its underlying death spiral mechanism (Wilson and Zillante, 2010). In other words, the discussed phenomena of rationing and red-lining exist in credit markets.

Figure 5 demonstrates market outcomes for informational asymmetry. No considerable asymmetry exists between quality certainty and unknown quality q1. Market activities are not diminished. From the quality of q1 up to the also unknown quality of q2, market activity is reduced. If quality uncertainty reaches point q2, the market breaks down. In a market of certain goods (like banking services), the most important skill is identifying their quality. Additionally, Akerlof (1970) gives the example of credit markets in underdeveloped countries, where market mechanisms are out of order due to personal knowledge, as demonstrated by extortionate rates. However, he explains that counteracting factors like guarantees or brand names solve these market imperfections.

Figure 5: Market outcome for informational asymmetry

Essentially, market breakdown is a Walrasian equilibrium where demand and supply equalize at zero (Wilson, 1980). It presumes that all market participants are price takers. If buyers act as price makers, this equilibrium is highly probable. However, if sellers act as price makers, equilibrium can take multiple forms because the market is ruled by the interaction between the expectations of both sides agents. However, the discussion of the bank-optimal interest rate in Section 3.1.4.3.3 shows that credit markets are not cleared by Walrasian equilibrium.

Boundaries of Akerlofs (1970) model

The lemon model can be extended to service markets, but sometimes markets do not react according to the model (Kim, 1985). In a laboratory experiment, Kirstein and Kirstein (2006) demonstrated that agents do not act perfectly rationally. However, they deploy unspecified goods with minor prices. This may indicate low involvement possibly counteracting rational behaviour.

Even if Akerlof (1970) uses the example of rural credit markets, his model seems to be inappropriate regarding credit markets because they are not primary markets. Their subject is not quality-related goods but money with its unified quality. Moreover, credit markets legal claims are not simultaneously fulfilled as in purchase contracts (Spremann, 1990). The contrasting position that the model is appropriate relies on the view that loan amounts are prices for participation in a financial position (Terberger, 1987). However, this reasoning seems to be artificial because it contradicts the view of interests as prices. Moreover, not every market needs to be a market for lemons (Kim, 1985). The existence of lemons in the market does not directly lead to market reduction or market breakdown if their number is sufficiently small (Dejong et al., 1985b). Accordingly, quality uncertainty may generate different outcomes, like rip-off markets or reputation formation (Dejong et al., 1985a).

In rip-off markets, sellers cheat buyers by offering low quality and getting prices for high quality (Dejong et al., 1985a; Wilson and Zillante, 2010). If buyers rely too much on sellers announcements, they tend to overpay quality (Forsythe et al., 1999). The existence of rip-off markets is significantly observed (Dejong et al., 1985b). However, sellers may be unaware that they are selling rip-offs, just posting prices regardless of quality (Wilson and Zillante, 2010). According to Akerlof (1970), this will diminish buyers quality expectations and prices and may finally break down the market. However, this assumes that the possibility of withdrawal does not always exist. For instance, corporate customers need at least one account for their business and are only able to limit its use. Thus, the existence of rip-off markets depends on buyers ability to decide between staying in the market deliberately or withdrawing (Dejong et al., 1985a). Essentially, rip-offs outcome is a pooling equilibrium with prices near the buyers average value (Wilson and Zillante, 2010, p. 8).

Positioning strategies

When facing serious but solvable asymmetric information problems, market participants try to position themselves in the market. They simultaneously use signalling and screening strategies due to informational asymmetrys nature (Rosenman and Wilson, 1991). Signalling or screening devices are not necessarily very extraordinary. Sometimes, the simple recognition of doing or leaving actions may be sufficient.

Reputation formation counteracts sellers suffering because reputation works as a signal (Shapiro, 1983). Moreover, it economizes counterpart screening and reflects market beliefs about suppliers reliability (Stigler, 1961; Boot et al., 1993). However, reputation does not improve markets to a perfect informational level (Shapiro, 1982). It is a long-run strategy regarding an agents future performance (Dejong et al., 1985b; Dewally and Ederington, 2006). Its non-price dimension means offering high quality as well as developing brands (Klein and Leffler, 1981; Shapiro, 1983). Figure 6 demonstrates that sellers quality is higher than buyers expect and that buyers are only willing to pay average prices ex-ante. Sellers build their reputations by offering products for less-than-competitive market prices (Klein and Leffler, 1981; Shapiro, 1983). Buyers may plausibly use the quality of products produced [...] in the past as an indicator of present or future quality (Shapiro, 1983, p. 659). Nevertheless, if quality is set once-and-for-all [...] a clear rationale for reputation formation is given (Mendelson, 1985, p. 820). Alternatively, sellers provide positive experiences to customers and deliver unexpectedly higher quality than required (Shapiro, 1983; Wolf and Myerscough, 2007). Even banks risk taking within loan contracts works as a reputation-building signal (Degeorge et al., 2004). Partners repeat business as long as they believe in their counterparts reputations (Shapiro, 1983; Dejong et al., 1985a). Laboratory studies have confirmed that reputation improves markets, so sellers become able to sell their higher-quality products at appropriate prices (Dejong et al., 1985a; Wolf and Myerscough, 2007).

However, reputation formation needs significant time (Shapiro, 1983). Interestingly, higher prices themselves tend to build reputation and force suppliers to deliver higher quality (Dejong et al., 1985a). In equilibrium, items must earn a premium to amortize the initial costs of reputation formation (Klein and Leffler, 1981; Shapiro, 1983; Dejong et al., 1985b). The reputation rule prevents buyers and sellers misbehaviour. They are protected against quality reduction by sellers sunk costs because of direct losses for buyers reducing the demanded quality or leaving the market (Klein and Leffler, 1981; Shapiro, 1983). Therefore, buyers value reputation rationally, and sellers with superior reputations receive higher prices (Dewally and Ederington, 2006).

Wilson and Zillante (2010) show that repeated trades allow sellers to form reputations, but this is counterbalanced by their own uncertainty about competing market prices. This interaction can lead to more-efficient outcomes. They also find that providing higher quality leads to a higher probability of a pooling equilibrium where all levels of quality are sold for the same prices if the costs for adding quality are low. This is the situation in banking markets for extremely unified account and payment services.

Figure 6: Prices association with reputation formation

Other counteracting factors that signal high quality are achieving third-party certification, offering warranties, and simply disclosing information; however, in contrast to reputation formation, these are short-run strategies (Dewally and Ederington, 2006). Dewally and Ederington (2006) show that certification from a respected third party is most effective because it results in higher prices independently. Buyers honour the costs of certification because it is a serious signal and reduces their risks. Accordingly, certification is widely used. Banks possess some certification from their sovereign supervision. It can be used to increase prices more so than reputation formation can. Nonetheless, certification and reputation appear to be substitutes (Dewally and Ederington, 2006, p. 726).

Often, information about products or services is poor. Seller may use warranties as signals when facing difficulties in conveying information directly (Grossman, 1981). Provisions of warranties change buyers expectations of product quality (Wiener, 1985; Gal-Or, 1989). They work only in competitive markets and as long as their costs do not rise too high. Otherwise, they seem to be less effective because of their realization costs (Dewally and Ederington, 2006). However, they may be a good choice for large-volume contracts, which regularly appear in banking.

Information disclosure is an inappropriate strategy because it is relatively easy to mimic and does not deliver reliable information (Dewally and Ederington, 2006). Moreover, sellers are expected to provide prospective buyers with information like advertising or manuals. Therefore, disclosures are not highly valued. In turn, failure to provide disclosures diminishes prices because it indicates lower quality.

If these strategies are inappropriate or impossible, the acceptance of underpayment could be a deliberate option for sellers (Kirstein and Kirstein, 2006). Banks rationally use anchors like accounts in corporate banking because corporate customers prefer to apply for loans at banks with which they have existing relationships (Akerlof and Yellen, 1987). In turn, buyers may accept being ripped off. For instance, they may accept high prices for car parts to preserve their cars utility. Similarly, bank customers may accept high prices for a certain service because their bank offers some other appreciated service.

Steady-state markets

Near to neoclassical economics are steady-state markets, where participants experience sufficient informational symmetry. Every market may be in a steady state. For instance, customers generally find the quality of payment services to be sufficient. Holt (1996) demonstrated in classroom games that pit markets are particularly efficient. Within a price-tunnel, market inefficiencies decrease with experience and public information about prices. Accordingly, the related strategy of market participants is to anticipate available information and act as rationally as possible. Exchanges are closest to this ideal because they use unified qualities and public prices. However, banks as financial intermediaries possess informational advantages over their corporate customers in this regard because they work in exchange markets.

Corporate banking service markets

Table 1: Market strategies for services

Table 1 summarizes market strategies regarding informational states, ordered by grades of asymmetry. For the worst case of unsolvable asymmetry, market participants use avoidance strategies like deal reduction or, if possible, withdrawal. If serious but solvable asymmetry rules the market, they try to position themselves using reputation formation, employ counteracting factors (like certification, warranties, and information disclosure), or just accept a disadvantageous position for other reasons (e.g. anchoring). In steady-state markets, participants simply anticipate available information.

However, all market formations require sufficient information transmission between agents and principals. Basically, these processes are shaped as indirect transmission. Screening appears to be less important because buyers are averse to considerable information costs (Dejong et al., 1985a; Degeorge et al., 2004). Thus, direct transmission rather works to confirm expectations. Nevertheless, prices express underlying quality expectations but are sensitive to informational conditions.

Table 2: Examples for market strategies in banking

Table 2 illustrates the market strategies in banking by giving examples. Reactions to unsolvable asymmetry could be based on exogenous effects, like customers uncertainty regarding stock markets baisse or customers unexpected losses due to banks opportunistic behaviour in concealing financial instrument risks. Serious asymmetry generates different positioning strategies. These include reputation formation for quality uncertainty, certification of products like government-guaranteed public pension plans, warranties to limit the interest risks of structured investments, the simple disclosure of interest rates in money markets, or information anticipation for the branch-wide uniformity of payment services. Accordingly, linking additional services or products to credit-related information but not to instruments is difficult because most strategies require an existing market position. However, the use of reputation seems possible. Therefore, additional products or services should be related to a banks core competences in credit markets because banks may possess sufficient informational advantage in this context. These competences are risk taking, risk recognition, and the evaluation of customers credit quality. Accordingly, the following sections examine whether credit markets allow banks to build advantageous knowledge to be used as links.

Credit markets Informational problems

The following sections attempt to create an understanding about informational states in credit markets. The main result is that the loan business does not need informational equalization like service markets do because credit markets operate quite differently from most other markets (Clemenz, 1986, p. 1). In credit markets, there is a close bankcustomer relationship, several banking services are produced jointly, and default risk shadows loans. Borrowers like to use a single lender because borrowing from multiple lenders is disadvantageous (Petersen and Rajan, 1994). Basically, banks deploy relationship and transaction-based lending to reduce their informational problems (Harhoff and Krting, 1998; Berger and Udell, 2002).

Under relationship lending, banks acquire some proprietary information over time through contact between the lending officer and the customer. The pricing and availability of credit hinge on the relationships strength. Thus, it works similar to reputation formation. It requires lending officers high grade of authority but creates agency problems within lending organizations. The officer is best informed about customers but is subject to differing incentives, which might lead to overinvestment because of opportunistic contingencies like illegal kickbacks, jobs offered by customers, and personal friendships.

Transaction-based lending refers to hard information and means lending based on financial statements, assets, or credit scoring. Financial-statement-based lending relies on the evaluation of customers financial disclosure; asset-based lending makes lending decisions according to the quality of available collateral; and credit scoring adopts statistical methods in lending decisions. However, Krishnaswami et al. (1999) demonstrate that relationship lending and transaction-based lending do not differ entirely. In particular, repeated lending transactions within the same relationship allow information accumulation similarly to relationship banking. Accordingly, relationships evolve over time, but an increasing number of relationships reduce their scope (Degryse and van Cayseele, 2000).

Banks adopt standardized credit policies to avoid internal agency problems and because of regulatory supervision. The use of soft information that is difficult to verify opposes securitization (Berger and Udell, 2002). Thus, relationship lending diminishes with informational distance or enduring relationships because their value for banks decreases (Greenbaum et al., 1989). Accordingly, banks reputations play a minor role in credit markets. Nevertheless, they have particularly high reputations as credit risk assessors and monitors of borrowers (Ross, 2010).

Red-lining

Loan relationships are characterized by different needs. Borrowers are only interested in whether the bank possesses the applied amount of money, while banks are essentially interested in contracts risks (Smith, 1972). This tendency to neither search for information nor shop for credit makes credit an uninformed purchase (Dauten and Dauten, 1976, p. 62). In contrast, lenders recognize new loans riskiness in particular because they expect borrowers credit quality to decline (Skinner, 1994). Accordingly, credit markets are characterized by lender screening (Milde and Riley, 1988). This basically explains why debtorcreditor negotiations appear rather superficially to be one-sided (Smith, 1972, p. 479). Banks adversely select distinguishably worse-risked borrowers through red-lining (Jaffee and Modigliani, 1969; Stiglitz and Weiss, 1981, 1987, 1992; de Meza and Webb, 2006). Therefore, a classification scheme based on readily verifiable objective criteria would appear as an efficient and effective device (Jaffee and Modigliani, 1969, p. 860). Thus, banks evaluate loan applicants credit quality and classify them effectively by using imperfect indicators (Boot et al., 1991; de Meza and Webb, 2000). However, all types of borrowers may be excluded for sorting, incentive effects, terms, and conditions because of low expected utility (Stiglitz and Weiss, 1987; de Meza and Webb, 2006). Accordingly, the amounts of collateral and customers equity affect the granting of loans because both are important contract conditions and quality indicators (Azzi and Cox, 1976).

Red-lining also prevents weak-quality applicants (de Meza and Webb, 2006). Unfortunately, credit markets widely fail in self-selection because dishonest applicants disguise their real riskiness and appear to be good borrowers (Jaffee and Russel, 1976). Red-lining increases lender benefits because both adverse selection and self-selection prevent losses (de Meza and Webb, 2000). Terminating the loans of poor-performing borrowers works similarly because they will not get any loans in the future (Stiglitz and Weiss, 1983). However, borrower quality remains inexactly evaluated, even if banks improve their selection abilities over time (Thakor, 2005). Nevertheless, informational problems create opportunities for worse customers to take a free ride on loans, and banks need to avoid being harmed (de Meza, 2002).

Figure 7: Red-lining

Figure 7 visualizes the concept of red-lining for a normally distributed number of loan applicants. Zero quality represents a 100% probability of bankruptcy, while one represents a 100% probability of payback. The clear distinction of borrowers for certain quality grades allows red-lining of all customers with a quality grade less than a required minimum grade depending on the banks risk policy. In this example, the bank denies loans to all applicants with a grade less than 0.3.

Credit rationingRationing as rational behaviour

Additionally, the phenomenon of credit rationing appears. Banks require minimum credit quality; however, beyond certain loan sizes, interest rate rises do not prevent decreasing risk ratios (Hodgman, 1960). A banks aim is simply to find sufficiently good borrowers (Clemenz, 1986). Therefore, credit availability is more important for customers than interest rates are because a fringe of unsatisfied loan applicants remains. Stiglitz and Weiss (1992) demonstrate that credit rationing has three presumptions: (i) the lenders residual uncertainty, (ii) the sufficiently strong adverse effects of a change in interest rates, and (iii) lower expected returns to the lender than for other rationed contracts at the Walrasian equilibrium. Similarly, Jaffee and Russell (1984) assume that credit rationing does not occur when both borrower and lender treat the defaulting probability explicitly because moral hazard would disappear and default risk would be anticipated in interest rates.

In contrast, credit rationing also occurs in informationally perfect markets (Myers, 1977; de Meza and Webb, 1992). Credit rationing is a market mechanism that is useful for lenders to control their imposed externalities and for borrowers being forced not to take loans beyond the level necessary to avoid bankruptcy. Accordingly, credit rationing does not indicate market failure but works as a device for market allocation.

It is the (deadweight) costs of bankruptcy that generates rationing (Morgan, 1994, p. 91). Freimer and Gordon (1965) distinguish weak and strict credit rationing. Weak credit rationing means that banks vary loan sizes and raise interest rates up to a limit for a certain applicant. When practising strict credit rationing, a bank sets an interest rate and grants an amount up to a maximum to a certain customer but refuses to lend more. The authors reason that the maximum amount is highly inelastic to interest because of noninterest-rate advantages. They conclude that profit-maximizing banks rationally practise strict credit rationing. This is supported by Jaffee and Modiglianis (1969) model based on a theory of rational lender behaviour defining credit rationing as excess demand at the ruling commercial loan rate. However, they reduce credit rationing to be an optimal rate regarding the banks expected profit. They suggest that banks best survey markets by classifying customers into a small number of classes and charging each group with an individually optimal rate. Over time, banks will learn about the characteristics of their borrowers and improve grouping (Watson, 1984). Nevertheless, legal restrictions or social mores bind banks in charging widely different interest rates. Banks tacit agreement about classification prohibits underbidding and results in widespread rationing as long as banks distinguish borrowers credit quality imperfectly.

Market equilibrium

Every risk class of borrowers may be rationed, and rationing may occur at every contract (Stiglitz and Weiss, 1992, p. 695). In contrast, Jaffe and Modigliani (1969; 1976) point out that risk-free customers will not be rationed, but Chan and Thakor (1987) demonstrate that high-quality applicants surprisingly are rationed. Similarly, secured borrowers are more often rationed than unsecured borrowers (Berger and Udell, 1992, p. 1073). Banks experience a dilemma between the adequacy of collateral requirements and the violation of high-quality borrowers reservation utility (Chan and Thakor, 1987). De Meza and Webb (1992, p. 1278) pose that there is a bias against medium risk because rationing is greatest on projects of medium risk and with high fixed costs. Rationing does not increase monotonically with loan risk, but it turns when risk is sufficiently great for bankruptcy. Thus, heterogeneity in borrower groups increases the likelihood of rationing (Besanko and Thakor, 1987).

The most basic tenet of economics states that market equilibrium entails supply equalling demand and that different levels of demand and supply equalize at a new equilibrium price. Stiglitz and Weiss (1981) conclude that under these conditions, the phenomenon of rationing cannot occur but does in fact exist. Credit markets do not follow the simple law of supply and demand because they equalize in banks optimal returns but not in prices. Therefore, banks take interest rates effects on borrowers behaviour into account because they are not simply prices but affect borrowers actions regarding their reliance on their going concerns (Stiglitz and Weiss, 1981). Accordingly, interests are a noisy signal because they do not reflect all the available information (Grossmann and Stiglitz, 1976). Therefore, credit markets are informationally ineffective because market participants are unable to judge quality by interest rates (Spremann, 1990). For instance, interest rates not only express risk but also the availability of funds (Stiglitz and Weiss, 1987). Subsequently, theory fails to predict how interests react in the relationship between bank and borrower (Schenone, 2010).

Stiglitz and Weiss (1981) demonstrate that loan market equilibrium is characterized by credit rationing. They propose two types of rationing: quoting and the denial of loans. If all banks have equal judging abilities, no competitive forces will equalize the market. They define credit as rationed because banks deny loans to borrowers who are observationally indistinguishable from those who receive loans (Stiglitz and Weiss, 1981, p. 394). They relate interest rates to loan riskiness either by the selection of borrowers or as affecting borrower actions. Moreover, higher interest rates induce borrowers to invest in riskier projects (Stiglitz and Weiss, 1983). The inverse relationship between charged interest rates and incentives for borrowers to turn to more risky projects produces adverse selection. They also explain that interest rates as prices cannot clear the market when they simultaneously affect the nature of transactions. Therefore, non-price information is considered in loan negotiations (Smith, 1972). For instance, collateral and equity make the demand for loans effective and result in a combined equilibrating process due to interests, equity, and collateral (Azzi and Cox, 1976). When borrowers pledge collateral, their debt becomes less risky and their likelihood of being rationed decreases (Jaffee and Modigliani, 1976). Accordingly, rationing refers to maximum self-finance (de Meza and Southey, 1996; de Meza and Webb, 2006). Thus, loan negotiation and legal and social constraints together lead to credit rationing (Jaffee, 1972; Smith, 1972).

Bank-optimal interest rates

The time lag between settlement and fulfilment characterizes loan contracts. Lenders grant loans at the beginning and borrowers promise to pay back at maturity. Unfortunately, banks are unable to control all borrowers actions directly and solve their problems by formulating inducing conditions (Stiglitz and Weiss, 1983, 1987). Their expected return is maximized at a lower interest rate level (the bank-optimal rate) than credit markets would equalize at, without considering expected default losses (see also: de Meza, 2002). In turn, banks would not grant loans to borrowers willing to pay higher rates because this indicates lower quality levels for worse risks (Schuhmacher, 2000). Harhoff and Krting (1998) demonstrate that neither the duration of a lending relationship nor the number of competing lenders can explain interest rates. The bank-optimal rate represents an insurance mechanism where low risk subsidizes high-risk borrowers or projects (de Meza and Webb, 1987; de Meza, 2002).

Figure 8: Red-lining and credit rationing

Figure 8 demonstrates credit rationing (based on Figure 7). While all customers below the red line are excluded or rationed to zero, all other classes of loan applicants are randomly rationed, as shown by the randomly positioned crosses. Berger and Udell (1992) conclude that credit rationing is economically insignificant. However, borrowers and lenders face rationing. Borrowers try to solve their problem of being rationed by getting early credit commitments (Morgan, 1994). Alternatively, they structure debt financing or engage in several bank relationships (Bolton and Scharfstein, 1996).

Investment problems

In addition to red-lining and rationing, there are problems with banks overlending and customers overinvesting or underinvesting (de Meza and Webb, 2000; de Meza, 2002). These investment problems affect financed amounts and borrowers credit quality. Generally, cash-flow determines borrowers investment activities (Bergstresser, 2006; Richardson, 2006). Borrowers tend to overinvest for unexpectedly high cash-flow and to underinvest for low cash-flow (Stulz, 1990; Klock and Thies, 1995). Jensen (1986) defines free cash-flow as that left over after exhausting investment opportunities with positive NPVs. Thus, investment in projects with negative NPVs characterizes overinvestment. In turn, underinvestment involves leaving projects with positive NPVs. Overlending and overinvestment are based on unrealistic optimism due to an inability to bond unexpected cash flow (Klock and Thies, 1995, p. 394). Moreover, managers do not deploy optimal financial policies because shareholders always suppose that their incentives lead automatically to overinvestment (Stulz, 1990). However, banks monitoring activities are assumed to solve these problems (James, 1987).

DMello and Miranda (2010) find an abnormal investment pattern among unlevered firms. The monitoring processes for issued debt reduce overinvestment (Myers, 1977; Jensen, 1986; Stulz, 1990). In contrast, debt elimination raises it (Bates, 2005; Richardson, 2006). Finance policies are assumed to reduce investment problems but not simultaneously. Stulz (1990) demonstrates that strategies like diversification, hedging, and financial engineering influence managerial behaviour; in contrast, banks shareholders do not generally possess relevant knowledge.

Collateral

Ono and Uesugi (2009) suggest that collateral is complementary to relationship lending. Two types of collateralization are commonly used to solve problems in the credit market (Benjamin, 1978; Bester, 1987; Coco, 2002). Inside collateral involves utilizing the borrowers existing assets and does not increase the lenders default position. In contrast, outside collateral is pledged additionally to the borrowers assets and increases the lenders position (Chan and Kanatas, 1985; Boot et al., 1991; Berger and Udell, 1995). The lenders risk policy and collateral requirements are inversely associated (Stiglitz and Weiss, 1983; Watson, 1984). Collateral is assumed to increase the lenders expected return up to the value of the collateral (Watson, 1984). The very common use of collateral indicates the considerable benefits it brings (Coco, 2002). For instance, it subsidizes screening (Bester, 1985; Berger and Udell, 1990, 1995; Boot and Thakor, 1994; Coco, 2002). Additionally, entrepreneurs participation in lenders default risk through collateral affects expected credit quality (Jaffee and Russell, 1976; Terberger, 1987; de Meza and Webb, 1992).

Pledged collateral supports lending officers need to account for responsibility within their lending organizations (Coco, 2002). Collateralization delivers some objectivity because its valuation is widely based on third-party mercantile data (Berger and Udell, 2002). Nevertheless, lenders are biased to value collateral downward because of their realization costs (Barro, 1976; Benjamin, 1978). Collateral signals effectively because the asymmetric valuation of collateralized assets reveals gaps (Chan and Kanatas, 1985; Bester, 1987; Coco, 2002). For instance, borrowers willingness to pledge more collateral reveals overoptimism due to neglecting higher defaulting probabilities (Stulz and Johnson, 1985; de Meza and Southey, 1996). Moreover, levels of collateral are consistently associated with the financed projects quality, even if the borrowers risk attitude is determined by their level of wealth (Stiglitz and Weiss, 1981; Coco, 2002). Poorer entrepreneurs are more risk and collateral averse, and vice versa for wealthier entrepreneurs (Chan and Kanatas, 1985; Berger and Udell, 1990; de Meza and Southey, 1996; Coco, 2002). Additionally, highly collateralized loans are more likely to default (de Meza, 2002). Thus, collateral can be used to differentiate borrowers (Besanko and Thakor, 1987; Chan and Thakor, 1987). However, collateral requirement increases may induce borrowers to withdraw from credit markets. Nevertheless, collateral increases funding probability because it substitutes a lack of equity. Unfortunately, it tends to diminish the quality of financed projects (Stiglitz and Weiss, 1981). Therefore, Stiglitz and Weiss (1981) suggest a bank-optimal level of collateral requirements similar to the bank-optimal interest rate.

Collateral also solves lenders moral hazard problems (Boot and Thakor, 1994; Chan and Thakor, 1987; Coco, 2002; de Meza, 2002). It makes defaulting costly for borrowers and forces entrepreneurs to make more effort (Barro, 1976; Benjamin, 1978; Watson, 1984; Clemenz, 1986; Chan and Thakor, 1987; Boot et al., 1991; Boot and Thakor, 1994; Bester, 1994). Accordingly, an appropriate collateral scale forces borrowers most efficiently to keep lenders interests (Barro, 1976; Jensen and Meckling, 1976; Stiglitz and Weiss, 1981, 1992; Stulz and Johnson, 1985). The underlying mechanism is that collateral allows lenders to renegotiate effectively according to the level of collateral (Bester, 1994; Coco, 2002). However, collateral does not solve the borrowers problem of being rationed (Coco, 2002; Stiglitz and Weiss, 1992). Nevertheless, in single cases, rationing may be the consequence of an insufficient amount of posted collateral (Coco, 2002).

Collateral reduces lenders monitoring costs because it prevents borrowers from selling the collateral and thus becoming riskier. Similarly, it reduces borrowers contracting costs (Stulz and Johnson, 1985). Moreover, securing loans protects against liquidation costs, since there is no default (de Meza and Southey, 1996). Additionally, collateral often reduces interest rates because lenders costs decline for lower default provisions (Chan and Thakor, 1987). Thus, collaterals forcing character helps to control lenders interests (Boot, 2000). In particular, its seniority makes banks claims within the relationship credible because it allows intervention (Boot, 2000).

However, the use of collateral seems to be limited because larger and long-term loans tend to have lower collateral requirements (Bester, 1987; Boot et al., 1991; Harhoff and Krting, 1998). Nevertheless, de Meza and Southey (1996) suggest the possibility of calculating its minimum level.

The credit markets informational situation

Generally, borrowers are assumed to be informationally advantaged compared to lenders without evidence (Smith, 1972; Dauten and Dauten, 1976; Milde and Riley, 1988). However, market participants current actions cannot be treated as evidence because customers do not take unknown risks through loans and, therefore, do not express informational needs. Deliberate direct information transmission solves the problems generated by red-lining and rationing (Milde and Riley, 1988). Banks require additional information and customers deliver it. Thus, credit markets do not require perfect informational equalization.

Banks monitoring indicates utility for customers because it optimizes financial policies (James, 1987). Thus, banks may have partial informational advantages that can be used to link other monitoring services. For instance, they may be able to prevent customers investment problems. Walton (2010) explains that delegated monitoring is particularly advantageous for companies that have bad managers but do not want to hire and inform external experts. However, banks already possess a lot of information. Therefore, they do not necessarily rely on managers information. If borrowers have pledged collateral, banks are in a strong position and have acquired some experience with successfully influencing borrowers strategies (Barro, 1976; Jensen and Meckling, 1976; Stiglitz and Weiss, 1981, 1992; Stulz and Johnson, 1985).

Unfortunately, market states do not allow direct inferences regarding the relationship between banks and borrowers because the nature of the single relationship may be different. Therefore, the following sections analyse customer levels.

Information on customer levelsAgency theory

Agency theory is concerned with problems between cooperating parties when one, designated as the agent, acts for, on behalf of, or as representative for the other, designated the principal, in a particular domain of decision problems (Ross, 1973, p. 134). It looks at the idealized relationship between contract partners regarding the delegation of responsibilities. Alternatively, this relationship is also analysed by the behavioural prospect theory introduced by Kahnemann and Tversky (1979) or Hart and Moores (1988) contract theory. However, agency theory surveys loan relationships as more likely and simplified in relation to loan contract conditions and is more close to financing literature. Therefore, the latter is used to generate the understanding about information on customer level.

Credit markets are characterized by a reversed double relationship (Smith, 1972; Holland, 1994). Banks act as borrowers agents in financial markets because they have access to them. In turn, the relationship is reversed because borrowers administer banks capital. Therefore, conflicts arise due to the cooperating partners different interests (Breid, 1995). Agency theory depicts the conflicts as simplified. Therefore, it contains the danger of falsification. However, agency theory is appropriate regarding loan relationships because it demonstrates incentive effects and the sharing of uncertain outcomes (Terberger, 1987). Contract partners interactions and the effects of loan contracts are central in financing. Regarding loans, they can be reduced to problems of decision making under uncertainty (Terberger, 1987; Kiener, 1990). However, the loan-granting decision does not solely lie with the bank.

Both economic literature and banking literature describe loan contracts equally by legal claims. Initially, the lender grants a certain amount and the borrower promises to pay back at maturity. If the borrower fails, the lender will only get the highest possible recovery amount. Agency theory assumes borrowers are better informed. Therefore, lenders can only use average information to judge borrowers quality (Terberger, 1987; Fama, 1980). However, the notion of borrowers having superior information remains an assumption without evidence. Moreover, a conceptual divergence between a tacitly informed borrower and an averagely informed lender exists. The borrower has special information about their own project and the lender has unspecified average information. A question remains regarding which partners information may be superior, due to the different nature of the information held.

Agency problems

In loan relationships, borrowers control the results (Terberger, 1987). Unfortunately, banks are unable to monitor borrowers decisions perfectly (Ross, 1973). Therefore, they use contract rules or changes in result sharing to counteract borrowers opportunistic behaviour. If borrowers do not fulfil their contracts, penalties are enforced.

Figure 9: Agency model

Lenders face the informational problems mentioned in Section 3.1.2 (Spremann, 1990). They characterize loan agencies for certain states of decision making, which have a sequential course (Kiener, 1990). Initially, both principal and agent evaluate whether they want to contract because both are uncertain about the contracts quality, but the lender faces higher risks due to the loan contracts risk-shifting effects. Figure 9 depicts agency theorys three phases regarding informational stances. The banks problems are quality uncertainty, holdup, and the moral hazard of the borrowers opportunistic decisions.

Uncertainty may arise endogenously or exogenously. However, both parties face exogenous uncertainty. Therefore, agency theory disregards it because both parties are equally uncertain.

Appropriate behaviour

In loan contracts, lenders are particularly uncertain about borrowers credit quality. Therefore, their problem is to distinguish good and bad borrowers (Spremann, 1990). Their informational channels are noisy, and they need to decide early and without complete information. Borrowers counteract quality uncertainty and adverse selection by revealing their characteristics (Spence, 1976). Accordingly, quality uncertainty is associated with borrowers self-selection or signalling and lenders screening as appropriate behaviour (Spence, 1973, 1976; Kiener, 1990).

Screening and signalling are related but describe borrowers and lenders different views. Theoretically, the borrowers choice of interest rates demonstrates their intended level of effort because choosing a higher rate induces lower effort levels (Coco, 2002). Similarly, the choice of loan size and interest rate informs the bank about the borrowers expected defaulting probability (Spence, 1976). However, it is difficult to identify good borrowers, and to do so requires the bank to use a variety of screening devices (Stiglitz and Weiss, 1981, p. 393). The willingness to pay a certain interest rate is a screening device because borrowers with high defaulting probability may pay higher rates. However, when borrowers heterogeneity and asymmetric information does not concern directly the projects quality but some lenders feature [...], perfect screening may be unattainable (Coco, 2002, p. 209). Nevertheless, signalling allows lenders to screen and distinguish borrowers.

Contingent contracts are also signalling devices (Spence, 1976). Loans are contingent contracts, and they transmit information and transfer risks from one party to the other. They offer an options menu that allows banks to observe borrowers quality directly because they implicitly require credit quality information. Unfortunately, they are only efficient if banks are risk neutral. If banks are risk averse and borrowers are less risk averse, risk transfer costs arise. Nevertheless, contingent contracts are effective if they ultimately observe quality for a sufficient duration. Other signalling devices include borrowers accepted costs of sending a certain signal (Spence, 1973, 1976). Such devices can also be used in loan contracts but do not shift risks in this context.

Agency theory accepts that principals may be better informed than agents, but this is widely disregarded because of the assumption that it would be advantageous to inform the agent (Kiener, 1990; de Meza and Southey, 1996). For instance, this case is realized when a trader knows that certain shares are undervalued and contacts a broker to make a purchase of them. However, this trader has a double role. He is an agent regarding the purchase and also an opportunistic participant in the market. Nevertheless, informational discrepancies are solved if the principal is able to attain values for different probabilities (Demski and Feltham, 1978).

Holdup occurs, for instance, when the borrowers economic position decreases and causes higher risks. The lender will be damaged by the results or the borrower will not pay back at maturity and will require prolongation of the loan term. This relies on existing incentives to undertake riskier projects and should not be confused by moral hazard (Hartmann-Wendels, 1989). Risks may increase due to descending economic cycles or poor entrepreneurial decisions. Although banks may view this as unfair, banks are unable to force borrowers either by legal claims or by physical power to change behaviour (Spremann, 1990). Only the possibility of loan denial in the future affects borrowers behaviour.

Banks decide to grant loans but cannot reverse their investments because borrowers use the money for their businesses. Banks implicitly need borrowers to be fair, but fairness is not explicitly agreed. Therefore, banks aim to immunize themselves against the missing fulfilment of their implicit claims (Spremann, 1990). Accordingly, they deploy contract conditions and collateral to generate authority and hierarchy (Kiener, 1990; Spremann, 1990). Regular review minimizes holdup uncertainty over time (Breid, 1995).

Lenders take the risk of moral hazard, which is defined as borrowers opportunistic behaviour to increase their own positions, even if they harm their lenders (Terberger, 1987). Unfortunately, moral hazard remains hidden because banks are unable to distinguish exogenous risks and borrowers behaviour (Spremann, 1990). Therefore, banks face the problem of becoming aware of adverse opportunistic behaviour (Kiener, 1990). Accordingly, they set out conditions to make their implicit expectations effective. These conditions are mainly linked to results to avoid conditions about an unlimited number of possible states (Marshall, 1976). The costs of risk avoidance increase in relation to final loss states, where the effort to avoid risk remains insufficient. Borrowers are the first risk owners in a loan contract but they shift this risk ownership to the lenders. Therefore, banks reduce risk shifting by eliciting borrowers higher risk participation using incentive contracts. However, optimal risk allocation cannot be reached because incentive rules contain contrary effects (Kiener, 1990). Nevertheless, financial intermediation seems to solve the issue of moral hazard through information production (Leland and Pyle, 1977; Campbell and Kracaw, 1980).

Agency costs and values

The separation of the ownership and control of a business is explained as efficient economic organization because firms are a set of contracts (Fama, 1980). In loan contracts, the control of decisions and the ownership of capital are also divided. However, contracts effectively improve teamwork productivity and quality assurance (Alchian