Relationship Lending and Entrepreneurial Behavior: A Game-Theoretic-Based Modeling

Introduction

In a transaction, economic agents will negotiate to maximize their own value and wealth. This is a general economic theory. For most of the economic transactions, it is difficult to empirically prove how value is created due to lacking data. The objective of this research is to demonstrate that improving relationships incentivizes economic agents, such as banks and entrepreneurs, to interact. Maskins (2001) defines incentive as the motivation to do what a principal wants them to do. The theoretical model developed herein proves that when a relationship is weak and is not considered in economic transactions, thereby causing a bank to disregard a small business entrepreneur’s actions, both economic agents will lose economic rents. On the other hand, when a relationship is strong and an entrepreneur’s actions are observed, the resulting economic rents will be such that each party will be better off building a relationship than not building it.

Relationship lending is only one of at least four different lending methods banks use to provide credit to small businesses. Berger and Udell (2002) mention that the most frequently used lending methods are financial statement lending, asset-based lending, small business credit scoring, and relationship lending. The first three methods are also called transaction-based lending, and they focus on hard quantitative information. Relationship lending strictly focuses on pure professional interaction. A bank will have information about a borrower’s characteristics through his or her exerted effort, education, business ideas, future plans, failures, financial and production constraints, etc. As this interaction becomes stronger over time, the lending conditions change. Banks have big incentives to interact with small businesses using the relationship lending technique. Banks’ contact with entrepreneurs will enable them to solve problems associated with information asymmetries, adverse selection, and moral hazards, and over time, this contact will help them better understand characteristics of entrepreneurs. These interactions also tend to elicit commitment from entrepreneurs. As the relationship between the bank and the entrepreneur grows get stronger, the entrepreneur will be willing to pay back his or her loan under any circumstances, looking for other financial sources to avoid default in times of distress. The moral hazard problem that banks used to have with small business entrepreneurs will be diminished when a great deal of effot is exerted to the project that the bank is financing. An entrepreneur is better off exerting strong effort rather than weak effort when the bank monitors his or her daily activities. If he or she exerts weak effort and the bank is observing that effort, the bank is likely not going to give additional help. If the entrepreneur defaults for external reasons, like a recession, but exerted strong effort, the bank may have extra stake in the company if it helps the entrepreneur in this distressed situation.

In this paper, I use game theory to model the relationship between banks and small businesses entrepreneurs. The model tells an economic story about how banks and small business entrepreneurs interact. A major conclusion of the model is that the presence of a strong relationship assigns rents to both the bank and the small business, whereas in the presence of a weak relationship, both agents miss the opportunity to detect and distribute these rents. In particular, I use subgame Nash equilibrium to find the optimal solution for a strong and a weak relationship game. In a strong relationship game, in which actions are observed, if the entrepreneur is committed to exerting strong effort, the bank will add cash to the project if things do not go well. In a weak relationship game, the bank will always cash collateral if things do not go well no matter the effort exerted by the entrepreneur.