A Two-step Analysis of Standardized Versus Relationship 

Bank Lending to Small Firms

By Polly Hardee, Ph.D., 2007. 36 pages. Houston, TX 77024, 

under contract number no. SBAHQ-05-M-0404

This report was developed under a contract with the Small Business Administration, Office of Advocacy, and contains information

and analysis that was reviewed and edited by officials of the Office of Advocacy. However, the final conclusions of the report do not 

necessarily reflect the views of the Office of Advocacy.

Purpose

Since small firms have very limited access to the 

publicly traded capital markets, these firms are 

very dependent upon commercial banks for financing. This, coupled with small firms being a strong 

engine for growth in the U.S. economy, warrants 

an environment of efficient capital allocation to 

these firms promoted by adequate bank credit.

In the past, lending to small businesses has 

been the province of small banks, as these banks 

possessed a comparative advantage in the small 

business loan market. That is, the structure of the 

smaller, simpler banking organization was more 

amenable to overcome the greater information 

asymmetries inherent in small firm financing. 

The information asymmetries were mitigated by 

the small bank’s proprietary relationship with the 

small business borrower, through a process termed 

in the literature as relationship lending. However, 

technological advancements have narrowed that 

information gap, thus allowing large banking 

organizations to become more prominent in this 

market through standardized lending practices 

such as credit scoring. As consolidation in the 

financial service industry continues, banks have 

become larger, with the number of small banks 

shrinking. With this structural change in the 

financial sector, the question of adequate credit to 

small firms continues to be an important economic policy issue, as large and small banks supply 

funds under different lending techniques. 

This analysis addresses that issue through a 

unique examination of evidence of standardized 

versus relationship lending methods in both total 

bank credit as well as credit emanating from the 

firm’s most important source of financial services, 

its primary bank. It contributes to the literature 

by using proprietary data associated with the 1998 

Survey of Small Business Finances Survey combined with banking data to produce a bank-firm 

match, thus allowing for a study of the banking 

structure at both the local market and credit provider level. Furthermore it analyzes total bank 

debt, whereas established studies focus on firm 

level debt of a particular credit instrument. Using 

a Heckman methodology, the adequacy of credit 

availability under the two diverse lending methods 

is explored. 

Overall Findings

The study reveals that relationship lending is 

inherent within the primary bank provider, whereas competing bank sources tend to employ standardized lending techniques such as credit scoring. 

Relating to credit availability, however, no clear 

dominance of one method over the other prevails.

Highlights

• Bank structure in the local market affects the 

likelihood of small firms having debt more so than 

the amount of debt provided by the source bank. 

• Large banking organizations reduce the likelihood of firm debt within the local market, but 

have insignificant effects as the source supplier of 

credit levels to firms. 

• Unit banks reduce both the likelihood of firm 

debt within the local bank market, and the levels 

of credit as the source banks. However, unit banks 

within large bank holding companies manifest 

apparent credit scoring, by higher credit levels from 

multiple bank sources.

June 2007 No. 305
• Primary bank credit levels are little affected by 

source bank structure, a result attributed to the relationship lending inherent in these institutions.

• Years with the source primary bank indicate the 

credit levels improve with a shorter relationship of 

this measure.

• Results from the firm characteristic variables 

underscore the evidence from the banking variables 

that multiple bank sources appear to utilize standardized lending practices such as credit scoring, with 

the primary bank engaging in relationship lending. 

This is particularly so with the ostensibly more cash 

constrained firms.

Methodology

The analysis relies on data from two sources, the 

demander of credit by small firms and the supplier of credit by banks. The latter is taken from the 

FDIC Summary of Deposits profiling bank data 

throughout the U.S. The firm data is extracted 

from the 1998 Survey of Small Business Finances 

(Survey), a nationally representative, weighted 

sample of small firms designed to reflect the target population of small, non-financial firms operating for profit within the United States. Besides 

firm demographics and broad financial statement 

variables, the Survey reflects the financial products and institutional sources used by each firm. 

In the public data of the Survey, the identity of 

the financial institution is not revealed, only its 

type. They are commercial banks and thrifts, credit unions, mortgage companies, finance and leasing companies, brokerage houses, and insurance 

companies. The financial products are varied services offered by these institutions, but this analysis 

focuses only on bank debt. This is debt from commercial banks, savings banks as well as savings 

and loans, since these are the main providers of 

credit to small businesses. The credit instruments 

in the Survey are classified into six categories: 

Lines of Credit, Mortgages, Equipment Loans, 

Motor Vehicle Loans, Capital Leases and Other 

Loans—loans not of the preceding types (primarily unsecured term loans). The debt is determined 

by aggregating the individual credit instruments 

from all bank sources as well as those from just 

the firms’ primary bank. This methodology coupled with the proprietary nature of the bank-firm 

match is part of the unique contribution of this 

study to the research community.

The model utilizes a two-step Heckman process 

at the firm level to control for sample selection 

estimation bias. The first step estimates the probability of a small firm obtaining credit, while the 

second step estimates normalized levels of credit 

for those firms having debt. A Heckman analysis 

is employed because there are reasons to consider 

that the decision whether to carry debt may have 

separate components than the decision concerning the level of debt. That is, the incentives to the 

financial institution provider in supplying credit 

may not be consistent with the demand preferences for debt by firms. Thus by explicitly modeling 

the decision process of the likelihood of debt in a 

Probit selection equation as a separate step from 

the decision of debt levels (conditional on firms’ 

having debt) in a linear equation, the differences 

in lending/borrowing behavior at both stages of 

the funding process are captured

This report was peer-reviewed consistent with 

Advocacy’s data quality guidelines. More information on this process can be obtained by contacting the Director of Economic Research at 

advocacy@sba.gov or (202) 205-6533.

Ordering Information

The full text of this report and summaries of other 

studies performed under contract with the U.S. 

Small Business Administration's Office of Advocacy 

are available on the Internet at www.sba.gov/advo/

research. Copies are available for purchase from:

National Technical Information Service

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Springfield, VA 22161

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www.ntis.gov

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