The Value to Banks of Small Business Lending

By Joe Peek, University of Kentucky; Lexington, KY 40506-0034

Under contract SBAHQ-05-M-0435 [37] pages.

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

and analysis that were 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.

This study investigates the contribution of relationship lending to the value of banks by estimating the 

market premium placed on the small business loan 

portfolios of banks. 

This approach contrasts with the previous literature that has focused almost exclusively on the 

value of lending relationships to the firms that obtain 

access to bank lending, finding that firms, both large 

and small, accrue substantial benefits. The underlying hypothesis of this study is that relationship lending is mutually beneficial, benefiting banks as well 

as the firms to which they lend. 

Such a finding would have important implications 

for bank behavior. For example, to the extent that 

small business lending increases the market value of 

banking organizations, consolidation of the banking 

industry that takes the form of reducing the emphasis 

on small business lending of acquired banks with a 

particular expertise in small business lending may be 

value destroying for the acquirer, and thus not in the 

best interests of shareholders. 

Overall Findings

The authors find that for commercial and industrial 

loans, small business lending does, in fact, add value 

to banking organizations overall. This evidence suggests that at least for small banks, the added revenue 

associated with relationship lending exceeds the 

added information costs associated with evaluating and monitoring small business commercial and 

industrial loans. Small business lending was found to 

be a profitable market niche for small publicly traded 

banking organizations in the United States.

Highlights

The authors provide direct evidence on the value to 

banks arising from relationship lending by estimating 

the market premium placed on the small business loan 

portfolios of banks. Among the findings are that:

• Small business loans in the form of commercial 

and industrial loans with original amounts of 

$1 million or less add 10.5 cents to the value of 

a banking organization for each dollar of such 

loans held in the bank’s portfolio relative to larger 

commercial and industrial loans.

• This value-enhancing effect emanates from the 

sample of the smallest banking organizations, those 

with assets less than $500 million.

• The value-enhancing effect arises primarily 

from holdings of the smallest category of 

commercial and industrial loans, those with original 

amounts of $100,000 or less, with the differential 

effect for the smallest category of banks being over 

28 cents per dollar of such small business loans.

• The authors find no evidence that small 

commercial real estate loans, which tend to be 

transactional rather than relationship loans, provide 

a differential effect on bank value beyond that 

produced by commercial real estate loans more 

generally. However, commercial real estate loans do 

produce value for the smallest category of banks.

Scope and Methods

The authors use data from four primary sources: the 

Federal Reserve’s Quarterly Consolidated Financial 

Statements for Holding Companies, the Federal 

Reserve’s Consolidated Reports of Condition and 

Income for individual banks (call reports), the 

Federal Reserve’s National Information Center database (NIC), and the Center for Research in Security 

Prices. The sample consists of the set of publicly 

traded banking organizations. Annual data for small 

business loans are obtained from the Small Business 

Loan Survey section of the June bank call reports. 

May 2007 No. 301
Because some of the key explanatory variables can 

be consistently collected only starting from 1994, the 

empirical analysis is based on annual observations 

from 1994 through 2005. 

The Small Business Loan Survey provides information on loans with original amounts of $1 million 

or less in two different loan categories: commercial 

and industrial loans to U.S. addresses in domestic 

offices (CI) and commercial real estate loans secured 

by nonfarm, nonresidential properties in domestic 

offices (referred to as commercial real estate loans, 

CRE). The survey also disaggregates these loans into 

three size categories based on original loan amounts: 

less than or equal to $100,000, more than $100,000 

through $250,000, and more than $250,000 through 

$1 million. Since data on small business loans are 

available only at the individual bank level and most 

publicly traded banking organizations are holding 

companies, the small business loan data were aggregated to the holding company level. For this purpose, 

all commercial and savings bank subsidiaries of the 

holding companies are identified using the Federal 

Reserve’s NIC database.

The sample excludes foreign-owned banks, as 

well as banks located outside the continental United 

States. Since some of the holding companies are 

financial services holding companies for which 

commercial banking activities are not their primary 

line of business, such organizations are excluded 

from the sample. Finally, the sample excludes 

observations with extreme values (outliers), defined 

as observations with values for the dependent 

and independent variables that are more than four 

standard deviations away from the variable’s mean 

value. After applying these filters, the sample is 

an unbalanced panel that includes a total of 4,333 

observations on 817 banking organizations.

In order to test the key hypothesis that relationship 

lending in the form of small business lending by 

banking organizations is value enhancing, the 

authors relate small business lending activity to the 

market-to-book ratio of the banking organization. 

They relate bank market value to the book values 

of assets and liabilities, and to the flows of income 

produced by off-balance-sheet activities, since the 

reported notional values are uninformative about the 

value of such activities. 

The authors’ empirical specification allows a 

disaggregation of the total market premium or 

discount placed on banks into its components by 

estimating separate valuation coefficients for the 

individual portfolio categories. The key hypothesis 

test is whether the estimated coefficients on bank 

holdings of small business loans are significantly 

greater than unity. If so, then small business lending 

adds to the market value of banking organizations. 

However, they focus on the differential effect 

of small business loans relative to that for total 

loans in that category in order to better control for 

the average effects of changes in the economic 

environment on all business loans, with a significant 

positive estimated coefficient on small business 

loans indicating that small business loans are value 

enhancing relative to larger loans. 

This report was peer reviewed consistent with 

the Office of 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

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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/

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