Relationship Lending: That Ship Has Not Sailed for Community Banks 
This study addresses the question of whether, or to what degree, relationship lending enhances the value of a banking organization, and thus its viability. It provides direct evidence of the value to banks of relationship lending by using the transaction prices for a set of target banks sold in merger and acquisition (M&A) deals in addition to the stock market values for a set of publicly traded banks to estimate the relationship between the book and market values of banks’ small business loan portfolios.
Key Findings
- For the target community banks sold in M&A transactions, small commercial and industrial (C&I) loans command a 23 percent purchase premium over their book values.
- The value-enhancing effect of C&I loans comes primarily from the smallest size category of C&I loans, those with original amounts of $100,000 or less, which are the most likely to be relationship-based. For those loans, the acquisition price premium is 39 percent of their book values.
- For publicly traded banks, a 31 percent market premium is associated with C&I loans with original values of $100,000 or less. The premium, however, materializes exclusively when these loans are extended by community banks, particularly small community banks with book assets of less than $2 billion that are more likely to rely on relationship lending that is based on the bank’s private information rather than the use of credit-scoring models.
- Because they are more transactional and tend to rely on collateral rather than relationships, small commercial real estate (CRE) loans do not appear to enhance the market value of community banks more than do large CRE loans.
Implications
The finding that small C&I loans enhance the market values of community banks suggests that, at least for these banks, the added revenue associated with relationship lending exceeds the added costs associated with evaluating and monitoring small business loans, although the estimated effect may also include the value of relationships emanating from the opportunity to profit from other lines of business with their relationship firms.
The finding that, unlike small C&I loans versus larger C&I loans, small CRE loans do not appear to enhance the market value of banks more than do large CRE loans could be related to the more transactional nature of CRE lending. Compared with C&I loans, CRE loans rely to a greater extent on the evaluation of physical collateral rather than superior soft information about a relationship borrower. As a result, the advantages stemming from information-intensive relationship lending based on soft information become relatively less important.
Regarding the findings related to the Great Financial Crisis, given that loans for commercial real estate and construction and most of the other types of loans in community banks’ portfolios were heavily discounted during the GFC, sustained value-enhancing effects associated with small business lending during this volatile period partially offset losses to those banks’ franchise values and contributed to their ability to withstand the turmoil.
Overall, the evidence of the value-enhancing effect of small business lending for community banks suggests that these banks can continue to play a positive role by making relationship-based small loans to small firms.
Abstract
This study provides direct evidence of the value to banks arising from relationship lending by estimating the market premium placed on banking organizations’ small business loan portfolios. Using data from the small business loan survey contained in the June bank Call Reports, we find that small commercial and industrial (C&I) loans add value to community banks both in absolute terms and relative to the value contributed by larger C&I loans. The value-enhancing effect of small business loans is observed primarily at small community banks, and it was present during the Great Recession as well as during periods of more normal economic conditions. Furthermore, the value creation emanates primarily from the smallest relationship-based C&I loans, those with original values of $100,000 or less, and at the smallest community banks. By contrast, small commercial real estate (CRE) loans, being relatively more transactional than C&I loans, do not contribute additional value to community banking organizations. The evidence is consistent with a positive role played by small banks making relationship-based loans to small firms.