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Material Source: Hitotsubashi University Author: lichiro uesugi

Role of collateral and personal guarantees in relationship lending: evidence from

Japan's SME loan market

1 Introduction

A key issue of interest in the recent literature on financial intermediation has been the role of relationship lending. Relationship lending is particularly common in the case of small business lending, because small businesses typically rely on bank loans for a substantial part of their financing needs but also tend to be informationally opaque. An important issue in this context is the use of collateral, which is a common feature of loan contracts between small firms and banks around the world, and a number of theoretical and empirical studies have examined why it is so widespread and how it relates to the incentives for borrowers and lenders and the borrower-lender relationship. For instance, it has been argued that in the presence of information asymmetries between creditors and borrowers, collateral may mitigate the problem of adverse selection (Bester, 1985; 1987) and/or the problem of moral hazard (Bester, 1994; Boot, Thakor, and Udell, 1991). Collateral also affects the incentives of creditors, who will use it either as a substitute for (Manove, Padilla, and Pagano, 2001) or complement to (Rajan and Winton, 1995; Boot 2000; Longhofer and Santos, 2000) screening and monitoring efforts. Another aspect of collateral that studies have concentrated on is that its presence may depend on the length and intimacy of the relationship between creditors and borrowers (Boot, 2000; Boot and Thakor, 1994; Sharpe, 1990). Existing empirical research has yet to reach decisive conclusions about the nature of these relationships.

This paper seeks to contribute to the existing literature on collateral using a unique firm-level data set of the small and medium sized enterprise (SME) loan market in Japan. Explicitly differentiating physical collateral (such as real estate) and personal guarantees by business representatives, we investigate how the use of collateral and personal guarantees affects the incentives of borrowers, lenders, and the relationship between them. More specifically, we examine the following three issues. First, we examine whether riskier borrowers are more likely to be required to provide collateral or personal guarantees. Second, we investigate how collateral and personal guarantees affect banks’ monitoring of borrowers. Third, we examine the correlation between the use of collateral and personal guarantees on the one hand and the closeness of borrower-lender relationships on the other.