Embeddedness and capital markets: Bank financing of businesses

Embeddedness and Capital Markets: Bank Financing of Businesses

GARY P. GREEN* University

of Wisconsin,

Madison

TSZ MAN KWONG The Open Learning

Institute

of Hong Kong

LEANN M. TIGGES University

of Wisconsin,

Madison

The article examines the social and economic dimensions of capital ABSTRACT: markets, particularly the effects of bank and capital market structure; lending criteria and bank policies; and demand for credit, on bank financing of businesses. A critical problem in most capital markets is that lenders have inadequate information to assess the risk and creditworthiness of loan applicants. We find that many bankers continue to use assessments of character as a signal of the potential borrower’s creditworthiness. Banking deregulation limits the range of signals available to lenders and therefore may have detrimental consequences for banks and local economies.

INTRODUCTION The social and political struggle over self-regulating markets has intensified in the last two decades in the economies of both developed and underdeveloped countries. The United States has deregulated several key industries (e.g., banking and transportation) in an effort to introduce greater competition. Many * Direct all correspondence to: Gary P. Green, Department of Rural Sociology, University of Wisconsin, 350 Agriculture Hall, 1450 Linden Drive, Madison, WI 53706. The Journal of Socio-Economics, Volume 24, Number 1, pages 129-149 Copyright @ 1995 by JAI Press Inc. All rights of reproduction in any form reserved. ISSN: 1053-5357

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developing countries have lowered their barriers to trade and reduced the role of government in their economies. This drive to create self-regulated markets is based on the argument that government regulation has stymied economic competition and growth. Despite movement toward greater dereguIation and elimination of trade barriers, social relationships continue to shape and limit markets. As Polanyi (1944) suggests, there is a double movement in market society, one pushing for self-regulating markets and the other for increased social protection. Block (1990) argues that postindustrial society pushes social relationships to the foreground; with the expansion of the public sector, the rise of modern corporations, and the growth of professional employment, the postindustrial transition reduces the level of marketness in economic activities. Thus, it is especially important to examine the social factors involved in the operation of markets in the advanced economies today. Our approach to understanding the current dynamics of the relationship between society and markets is to use the concepts of social embeddedness and signaling. Although many economists advocate self-regulating markets to achieve economic efficiency, they seldom study the working of actual markets (Block, 1990). Markets operate within a social and historical context that shapes the relations between economic and nonecono~c forces. Accordingly, it cannot be assumed that all economic action is regulated by market forces. At the same time, the embeddedness of markets within the social and historical context cannot override the functioning of economic activities. The goal of sociological analysis is to explain why and where markets are dominated by various social structures and relations. Rather than relying on grand theories to explain economics social action, we examine how specific social relations and economic factors influence market conduct within a particular historical context. Most of the research on the sociology of markets has been on labor markets; much less work has been done on the social nature of product and capital markets. This article directs attention to the understudied area of capital markets. ~peci~cally, we examine how the organizational features of capital markets and managerial policies influenced the allocation of credit in one set of small communities in 1990. As organizational structure changes in response to the deregulation of banking, social relationships between lenders and borrowers are restructured. Efforts to deregulate the banking industry during the 1980s increased the degree of marketness and the importance of social relations in capital markets. Our central argument is that deregulation has shaped the extent to which social ties, as opposed to rational action, dominate in the functioning of capital markets. Thus, we are trying to understand how the organizational and social context influences the operation of capital markets. Our research contrasts the neoclassical economic perspective with embeddedness and signaling arguments to understand economic and social forces in capital markets.

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Embeddedness and Capital Markets: Bank Financing

THEORETICAL

ISSUES IN THE OPERATION

OF CAPITAL MARKETS

Granovetter (1985, p. 487) summarizes the social embeddedness argument in the following manner: “Actors do not behave or decide as atoms outside a social context, nor do they adhere slavishly to a script written for them by the particular intersection of social categories that they happen to occupy. Their attempts at purposive action are instead embedded in concrete, on-going systems of social relations.” Social relations play an important role in generating trust and discouraging malfeasance in economic transactions. The embeddedness position points to the tendency for economic transactions to occur among individuals of known reputation. For example, many businesses are linked with one another to reduce the risk and uncertainty of making transactions with other firms (Granovetter, 1984). Granovetter does not deny that markets may be constituted by rational actors. Markets, however, consist of both social relations and rational action. Much economic sociology operates either at the macro level, focusing on structural changes among industries and on the organization of markets, or at the micro level, examining how social ties and interaction shape economic transactions. The concept of social embeddedness has relevance at both levels of analysis. For example, personal ties and contacts play an important role in influencing how successful individuals will be in obtaining credit from lending institutions. At the institutional level, we follow Polanyi’s analysis of markets and argue that attempts to commodify money will be never be complete. Polanyi argues that land, labor, and money are fictitious commodities and have never been allocated solely on market mechanisms. Deregulation promises to impose greater competitiveness on capital markets, but these markets continue to rest on political and social factors. The social and political foundation of capital markets is most evident in the recent attention given by bank regulators to community reinvestment, which points to the social responsibility of lending institutions. Future mergers in the industry will depend increasingly on demonstrating that the institutions have met the criteria for community reinvestment. Following Granovetter, we argue that capital markets are embedded in social relations that influence access to credit among borrowers. The strength of ties between lenders and borrowers will determine the accessibility of capital, although the strength of ties may be relatively weaker in formal markets than in informal capital markets. Weak ties, although involving a restricted amount of time and emotional intensity, are an important mechanism for obtaining information for both lenders and borrowers. Without these ties, lenders lack important information to make decisions on loan applications. Some economists also have rejected the version of neoclassical theory that emphasizes perfect and costless information (Spence, 1974; Stiglitz & Weiss, 1981). They argue that it is often difficult for market participants to obtain

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sufficient information to make rational decisions. For example, an employer may find it difficult to assess the productivity of employees before they are hired. As is the case to be studied here, lenders often face the same problem in evaluating potential borrowers. In these instances, individuals in markets rely on signals that may convey information to others in the market. Employers may use education, speech, and dress as signals of the future productivity of a worker. Lenders may rely on evaluations of the character of borrowers, or some other signal that they are not too high a risk. Like the sociological theory of embeddedness, the economic theory of market signaling suggests that markets will work most efficiently when participants have some knowledge of others in the market. In lieu of perfect information, buyers and sellers need reliable indicators of productivity, risk, and reliability. This information is best obtained in the context of ongoing social relationships. The economic literature suggests that lenders should not rely on willingness to pay higher interest rates as their sole criterion because it may lead them to lend to only the most risky borrowers (a situation economists refer to as adverse selection). Use of collateral as a criterion for lending also may increase the riskiness of loans because it may favor smaller projects. Thus, markets may not operate efficiently if lenders rely solely on market mechanisms to allocate credit. The signaling position of Joseph Stiglitz and Michael Spence and the social embeddedness theory of Mark Granovetter stand in marked contrast with neoclassical theory’s version of perfect and costless information. The signaling and social embeddedness positions stress that market participants often lack adequate information and that the allocation of scarce resources may be inefficient if individuals rely solely on price. According to neoclassical economic theory, a competitive capital market will make appropriate judgments in the allocation of capital across space and uses (Shaffer & Pulver, 1985). Of course, this assertion is based on the assumption that lenders have perfect and costless information; organizational influences and noneconomic motivations should have a negligible affect on the allocation of capital.

LITERATURE REVIEW AND HYPOTHESES The empirical literature on capital markets has identified three broad factors influencing the performance of commercial lending institutions: (1) the organizational structure of capital markets; (2) lending policies and managerial orientation; and (3) local demand for credit. We briefly review the empirical work in the social sciences examining how these factors influence the access to credit, cost of credit, range of services, and lending patterns among commercial banks.

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Capital Markets and Organizational Structure Capital markets in the United States have undergone a structural transformation over the past decade. Among the most important changes have been shifts in the structure of ownership, level of market concentration, and size of lending institutions. The major source of this change has been the elimination of many of the regulations surrounding the commercial banking industry. Congress eliminated the ceiling on interest rates commercial banks can pay on deposits, permitted banks to cross state lines, and allowed banks to become involved in activities not directly related to finance (e.g., real estate and insurance). Commercial banks continue to push for changes in banking with regulations to provide a “level playing field” in their competition nonfinancial corporations entering these markets. There continues to be debate over the merits of banking deregulation. Proponents maintain that deregulation will make the industry more efficient and competitive, thus resulting in improved services and lower costs. Critics claim that eliminating regulations will lead to greater concentration and monopoly power, ultimately increasing the costs of credit and services and draining capital from underdeveloped regions and communities. Deregulation also may lead to greater market instability as financial institutions are forced to take greater risks than they did in a regulated environment. Critics point to the recent crisis in the savings and loan industry as evidence of the deleterious consequences of deregulating financial markets. Underlying these debates is a struggle over the extent to which social influences should guide local capital markets. Proponents of deregulation contend that capital markets will be more efficient if regulations are removed; critics argue that regulations are needed to ensure that capital markets meet societal needs. This debate is reminiscent of Polanyi’s (1944) critique of selfregulating markets. Polanyi argued against the economists who contended that eliminating restrictions on markets would produce social benefits. Recent changes in the organizational structure of the banking industry should have implications for the relative importance of social relationships in determining who has access to credit from commercial banking institutions. Lender-borrower relationships are defined not only in the local context but also by the structural changes that are occurring in the industry. Deregulation, by raising the level of competition, constrains the discretion of lenders, which ultimately means that social values may play a smaller part in allocating capital. Although advocates of deregulation believe that reduced government intervention will force lenders to become more competitive and allocate capital more efficiently, one of the unintended consequences of deregulation will be a reduction in the information available to lenders, producing less than optimal levels of bank lending.

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We next examine the literature on the effects of market concentration, bank size, and branching status on the performance of lending institutions. All three dimensions have been influenced by banking deregulation. Although we are conducting a cross-sectional analysis, it is reasonable to assume that deregulation has led to an increase in concentration, in the number of branches, and in bank size. Thus, relationships between these variables and the performance of lending institutions serve as indicators of the effects of deregulation. Ownership Structure

Neoclassical economists generally assume that demand factors, rather than supply factors (e.g., organizational structure and managerial factors) are the primary determinants of capital flows.’ However, neoclassical economists acknowledge that supply-side factors may influence the behavior of lending institutions in imperfect markets. According to this position, the growth of branch banks should enhance the ability of lenders to meet the credit needs of businesses and consumers.2 As Ritter and Silber (1980, p. 108) assert: [SItate antibranching statutes, not economic circumstances are the primary determinant of the number of banks in the United States.. . . Most state legislatures that have maintained strict antibranching statutes have done so in the face of considerable evidence that branching would be more efficient and more viable than many small independent unit banks in providing the financial services needed by a dynamic economy.

The sociological literature suggests, however, that supply factors are primary influences on capital flows. For example, Green (1984) contends that a shift from independent banks to holding company affiliates and branch banks will have deleterious consequences for the availability of credit. He alleges that the growth of holding companies and branch banks will drain the capital from lagging regions and make it more difficult for small businesses and minorities to obtain credit in these markets. This argument is consistent with the social embeddedness argument which suggests that deregulation breaks existing social ties between bankers and local businesses by injecting formal rationality into capital markets: One might also speculate that the structure of capital markets affects the health of small establishments and especially firms. In particular, large, nation~y based banks, insurance companies and pension funds may find it difficult to develop the information about small, localized economic units required to determine which are credit worthy; thus, to the extent capital is centralized in such institutions, small units may be discouraged (Granovetter, 1984, p. 332).

Embeddedness and Capital Markets: Bank Financing

135

Thus, neoclassical economic theory and the social embeddedness/ signaling arguments make opposite hypotheses regarding the effects of ownership structure on lending practices. Neoclassical economic theory predicts that branching will benefit lagging regions and make credit more accessible. The embeddedness and signaling arguments suggest that the growth of absenteeowned financial institutions breaks established social relationships between borrowers and lenders, influences capital flows, and makes it more difficult for lenders to obtain information about potential borrowers. In many cases, loan decisions are made outside the local community at the office of the parent company. Empirical evidence on the issue of whether bank mergers drain capital from lagging regions and industries is mixed. Bank mergers do provide many benefits, such as improved services (Hayenga, 1975; Markley, 1984) and increased assets available for loans (Barkley & Potts, 1985; Barkley, Potts, & Mellon, 1984). Yet, there is evidence that branching drains capital from lagging regions under certain conditions (see Green, 1991). Overall this literature suggests that branching improves the variety of services offered (although at higher costs), does not influence the cost of credit, and may reduce access to credit among certain groups (minorities, small businesses, and the poor).

Market Concentration Neoclassical economists assume that lenders distribute capital in competitive markets and that market concentration reduces the willingness of lending institutions to take risks, thereby limiting the availability of credit, especially for small businesses (Milkove & Weisblat, 1982). Several studies, however, have found the level of capital market competition to be only weakly, though positively, related to the performance of lending institutions (Heggestad & Shepherd, 1986; Milkove & Weisblat, 1982). Deregulation may not affect the behavior of banks because deregulation has not increased the level of concentration in many cases; the branches are de nova rather than mergers. Thus, the development of new banks in the community increases the level of competition rather than lowering it. Banking deregulation may be creating more concentration at the national and regional levels, while producing more competition locally. Market concentration should be considered primarily an economic indicator of the relative competition in capital markets. The embeddedness and signaling positions do not really focus on this issue. One might reason, however, that in highly concentrated markets it is more difficult for a few lenders to maintain social ties with a broad segment of the community and to obtain adequate information from borrowers. In other words, less competition at the local level may make it more difficult for social ties to play a role in capital markets and for lenders to obtain information from a large number of borrowers. Thus, the

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social embeddedness and signaling concentration makes credit tighter.

OF SOCIO-ECONOMICS

positions

would

Vol. 24/No. 1/1995

predict

that

market

Bank Size Sociological studies have consistently found bank size to be a strong predictor of lending policies and practices (Green, 1984; Zey-Ferrell & McIntosh, 1987). Bank size increases the number of services offered, the percentage of assets committed to consumer and industrial loans, the size of loan limits, and formalization of lending policies (Milkove, 1985). Large banks prefer to lend to large firms because of the lower transaction costs involved relative to smaller borrowers. Zey-Ferrell and McIntosh (1987), however, contend there is much more to this relationship. Economic theory suggests that large banks will be less risk averse than small banks and, thus, would be more likely than small banks to allocate capital to small firms and lagging regions (Milkove, 1985). The embeddedness and signaling arguments consider bank size relevant insofar as large size may make it more difficult to maintain informal relationships between lenders and borrowers. Bank size should have a similar effect to that of branch banking organizations: small firms and new businesses will have more difficultly obtaining loans from large banks. To summarize our hypotheses regarding structural effects: the neoclassical economic argument is that competition, branching status, and bank size should improve the performance of lending institutions. The social embeddedness and signaling positions are that branching and large banks enervate social relationships and, therefore, should have a negative impact on lending behavior. loan Policies and Managerial

Orientation

Much less research has been conducted on the influences of managerial orientation and loan policies than market structure on bank performance (Markley, 1988). Overall, neoclassical economists assume that managerial practices and orientation should have a negligible effect on business financing. Loan policies and practices emphasize either social or economic criteria, or both. According to the embeddedness argument, banks using character as the primary criterion for evaluating loan applications would be more likely to make loans in the community. Because they are not using rational-technical criteria, lending institutions will rely more on social factors in their decision-making process. From the signaling position, the character of the loan applicant is valuable information necessary for efficient capital allocation. Our fieldwork, however, suggests that use of character is not always beneficial to local applicants. We discovered that “character” was frequently used by lenders to justify discriminating on the basis of race, class, or gender. In contrast, rationaltechnical criteria yield more opportunities for statistical discrimination.

Embeddedness and Capital Markets: Bank Financing

137

We expect that banks using collateral as their primary criterion for evaluating loans will rely much less on social relationships and, hence, will be more conservative in their lending practices. By focusing on collateral, bankers are using rational-technical criteria that limit the role played by social ties in the decision-making process. We argue that by placing an emphasis on character, bankers widen the available information on potential borrowers and permit social relationships to influence the availability of credit. Boggs, Sorenson, and Isserman (1988) found that using collateral as the major criterion for evaluating loans applications led to fewer loans and less aggressive lending than when capacity to repay the loan was used to evaluate the application. Generally, the literature suggests that when loan officers use collateral as their major criterion for lending, they tend to take less risk in their portfolios than when other criteria are used. The embeddedness and signaling arguments suggest that use of collateral has a conservative effect on lending. Policies for evaluating loans applications also affect bank performance. In particular, active involvement by the board of directors in the loan evaluation process reduces the number of small business loans (Boggs, Sorenson, & Isserman, 1988). This finding is consistent with results from other studies that loan limits on loan officers and formalization of lending policies restrict access to credit (Green, 1984; Zey-Ferrell & McIntosh, 1987). Economic theory suggests that active involvement by the board should have a negative impact on lending practices; loan officers would be more objective than the board in evaluating risk. Broadening the input into the evaluation process allows social factors to play a more important role. Involvement by the board of directors, therefore, should increase lending activity according to the embeddedness and signaling positions because of the extensive ties board members are likely to have in the community. Demand for Credit

Almost all of the previous studies in this literature have focused on the structural factors influencing the supply of credit (Markley, 1988). Very little work has been done to examine the effects of demand on the performance of lending institutions. The need to control for the demand for credit in studies of capital markets has become increasingly apparent. Neoclassical economic theory argues that demand for credit is the major factor influencing the allocation of credit in communities. According to this perspective, financial institutions do not create economic development, but are efficiently allocating credit to the most productive users. Thus, the larger the demand, the greater the availability of credit.3 The embeddedness and signaling arguments do not deny the importance of demand for credit in influencing the flow of capital but assume that supplyside factors are more important in influencing the extent to which social ties

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operate in capital markets. It is possible that increased demand for credit would place additional emphasis on social criteria because there are more good loan applicants available. Increased demand may push lending institutions to make credit more available. Similarly, increased demand may allow lenders to consider a wider range of signals than may be the case in a more restricted market. The key to our argument, however, is that the social embeddedness position does not assume that lenders will necessarily change their lending policies and practices because of this demand. The signaling position argues that lenders should not base allocation decisions solely on demand for credit (as influenced by price) but should use other sources of information. METHODOLOGY To date, Granovetter has relied heavily on case studies to build his theory, examining the role of social ties in job markets (1974) and in the persistence of small businesses (1984). To fully test his theory for capital markets would require data documenting the linkages between lenders and loan applicants. If available, these data would enable us to examine how social ties influence access to and cost of credit. Such a dataset, however, would also require information on all applicants who were formally or informally rejected for a loan. Because such data are not available and would be almost impossible to collect, we take a somewhat different approach. We examine the policies and practices of lending institutions in 25 Georgia communities based on interviews with bank officers. Counties were included in the sample if they had no city or town larger than 10,000 in population and were not located in a Metropolitan Area. Rural communities provide an excellent setting for studying the importance of social ties and signaling in capital markets. If we cannot demonstrate that social relations are critical to the functioning of capital markets in these settings, it will be difficult to maintain they are important in larger, more complex markets. In addition, deregulation appears to have had a more pronounced effect in rural than in urban markets (Green, 1991). We identified all commercial banks and savings banks in the 25 communities making any commercial and industrial loans. Seventy-five lending institutions were contacted in the summer and fall of 1990. Only two institutions refused to be interviewed, resulting in a response rate of 97%. Seven of the institutions were savings banks and the remainder were commercial banks. Each interview was conducted with a chief executive officer, president, or chief loan officer of the lending institution. A structured questionnaire was used that included questions on organizational structure; policies and practices regarding commercial and industrial loans; small business lending; and managerial characteristics. Each interview took approximately one hour.

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and Capital Markets: Bank Financing

139

Communities were selected on the basis of their major sources of income and on the size of their black populations. To stratify communities on the basis of major sources of income, we used the classification system developed by the Economic Research Service of the U.S. Department of Agriculture (Bender et al., 1985).4 The classification includes five major types of counties: agriculture, manufacturing, government, poverty, and retirement. These categories are not mutually exclusive, so a county could be allocated to more than one category. In addition to sources of income, the sample was stratified on the basis of the size of the black population. We divided the counties into three categories based on the proportionate size of their black population. A third of the sample was drawn from each category. According to Hayenga (1973, the boundaries of financial markets are defined by: (1) the willingness and mobility of the individual customer to investigate and use alternative financial services, and (2) the institutions offering the services needed by the individual. We found that commercial banks in our survey do the vast majority of their business in their own county. On average, banks reported making 86% of their commercial and industrial loans in the county in which they are located. Georgia has a relatively large number of counties (159) that form the basic social, political, and economic units for most communities. In states where there are fewer and larger counties, additional work may be required to identify capital markets. Although there are limitations to using political boundaries to define market areas, county lines offer a relatively good fit in this instance. There are three dependent variables in the analysis: the loan-to-deposit ratio, acceptance rate, and number of start-up loans. The loan-to-deposit ratio is an indicator of how much banking capital is retained in the community; it was measured as the reported total amount of loans divided by the total amount of deposits in the institution. For branch banks, the loan-to-deposit ratio is for the establishment, not the firm. Although there are a number of limitations to using this measure, it is the most widely used indicator of a lender’s investments in the community. The acceptance rate is measured by the reported number of accepted loans divided by the number of applications. The number of start-up loans is the number of loans to new businesses. We include several independent variables measuring the structure, management, and market demand for commercial lending institutions. The level of competition in the capital market is measured by the number of banks in the county. Branch banking status is coded as a dichotomous variable: 1 = branch bank; 0 = independent bank. Bank size can be measured by several indicators (e.g., loans, assets, number of employees).’ We chose number of employees as our measure because it is consistent with many previous studies in this area. Use of the other two indicators of size created multicollinearity problems. We asked bankers to indicate from a list of criteria the most important criterion in their loan evaluation process. Two dichotomous variables measuring

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Table 1.

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1 A995

Hypothesized Relationships of Independent Variables to Bank Performance h!eoclassica/

Economic

Signa/ling/Embeddedness

Structure Competition

+

Branch

+

+ -

Size

+

_

Collateral

N

-

Character

N _

+

Management

Board

+

Demand Per capita income Notes:

acceptance

+

+

The hypothesized

directions

rate, and number

for all three

dependent

variables

(loan-to-deposit

ratio,

of start-up loans) are the same.

+ = Positive Relationship -

= Negative

Relationship

N = No direction

hypothesized/no

relationship.

the most important criterion for evaluating loan applications were included: use of collateral and character, Other criteria such as evaluations of management capacity and cash flow statements represent the excluded category. A final measure of bank policy is the percentage of commercial and industrial loans that are considered by the board of directors for approval. Finally, we include a measure of demand in the local capital market. Although a precise measure of demand would include the number of loan requests (at various levels of cost), these data are extremely difficult to collect. In lieu of an actual measure of demand, we include 1988 per capita income in the county. This approach has been used in several studies examining credit disparities in urban areas (see Shlay, 1989). Ordinary least square regression analysis is used to estimate the effects of the independent variables. A summary of the hypotheses for the standard economic and social embeddedness positions is shown in Table 1. As can be seen, the social embeddedness/ signaling and neoclassical economic positions have different expectations for several independent variables. In a few instances, the two perspectives have similar expectations. FORMAL CAPITAL MARKETS AND BUSINESS

LENDING

Lending institutions in the sample are relatively small. Almost all (82%) of the institutions have five or fewer loan officers, and only a few of the loan officers spend more than half of their time in commercial and industrial lending. In 1989, the banks received an average of 150 loans applications, of which 111 were approved (see Table 2). The average size of loan was just over $60,000. Fourteen banks are branches and the remainder are independent banks.

Embeddedness and Capital Markets: Bank Financing

Table 2.

141

Information on Bank Portfolios Median

Mean Total number of loan applications

150

Total number of loans approved

111 $60,294

Typical size of loans

S.D. 111

173

,50,0~:

$43,192

138

Number of start-up loans Total value of start-up loans Number of commercial

$948,5E

$250,00:,

$2,483,3ii

and industrial loans

in portfolio

430

200

768

Total value of commercial and industrial loans Number of mortgages and personal loans

$9,680,672

$4,750,000

$12,630,187

42

16

67

$10,617,538

$500,000

$69,211,845

Total value of mortgages and personal loans Note:

N = 73

Our focus is on commercial and industrial loans because home mortgages and consumer loans are generally viewed by bankers as qualitatively different from business loans. In addition, commercial banks are not active in mortgage lending, and many of these loans are sold to secondary markets that establish the criteria to be used to evaluate applications. Banks in the sample approved 68% of their commercial and industrial loan applications. However, bankers reported that almost 12% of prospective borrowers were discouraged from applying by bank officers because interviews indicated that a loan would not be granted. Thus, the rejection rate would be somewhat higher if these cases were included. Unfortunately, we know very little about the social and economic forces operating in this informal screening process. Additional research needs to be conducted on the loan applicants that are screened at this stage of the process. These institutions hold an average of 430 (median = 200) commercial and industrial loans in their portfolios. On average, the total value of these commercial and industrial loans is nearly $10,000,000. The banks make an average of 10 start-up loans to businesses. The total value of these loans per bank averages $948,585. Although banks make relatively few of these loans, more than 80% of respondents indicated they would like to have more opportunities for start-up loans. Banks in the survey have a mean loan-todeposit ratio of 0.66, which is near the industry average. Commercial and industrial loans held in the portfolios of banks are distributed among a wide range of firms in terms of size (Table 3). More than three-fourths of the commercial and industrial loans are made to firms with gross sales of less than $500,000. Only 7.5% of their loans are made to firms with a gross sales greater than $1 ,OOO,OOO. Bankers are least likely to make loans to the smallest firms; only 14.5% of loans went to firms with gross sales less than $50,000. These firms tend to rely on informal sources of debt and equity capital, personal/family savings, and retained earnings (Elnajjar, 1993).

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Table 3.

Percent of Commercial

and Industrial

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1 I1

995

Loans

for Various Size Firms Sales

Percent

’

Acceptance

<$50,000

14.5

54.2

$50,000-$99,999

23.9

58.5

$1 oo,ooo-$499,999

38.9

62.7

$500,000-$1

15.9

64.7

7.5

67.0

>$ 1,ooo,ooo Note:

I Total

,ooo,ooo

Rate

may not equal 100 due to rounding error.

Loan applications by large firms have a higher acceptance rate for large firms than those by small firms. Firms with gross sales of less than $50,000 have an acceptance rate of only 54%; firms in the largest category (> $1 million in sales) have an acceptance rate of 67%. Again, it is important to remember that the acceptance rate does not include applicants who are discouraged from making formal loan applications. Banks might be expected to be more likely to discourage the smallest firms from making loan applications, which would reduce the real acceptance rate for these firms. The relationship between firm size and acceptance rates may be due to a number of factors, such as the risk of the operation or the loan policies of banks. There is evidence suggesting that many bankers who use a conservative set of criteria, relying primarily on available collateral, are less likely to lend to small businesses than bankers who use other criteria (Boggs, Sorenson, & Isserman, 1988). Similarly, many critics of deregulation have charged that changes in the banking system would place additional emphasis on formal criteria, such as cash flow statements, which may restrict further lending to small businesses (Green, 1991). To examine some of these issues, we asked respondents to rank the importance of a variety of criteria that could be used to consider a commercial loan request (see Table 4). Forty-five percent of the respondents indicated that the character of the person requesting the loan is the most important criterion used to evaluate loan applications. Twenty percent said that collateral is the most important consideration and an equal number considered cash flow as most important. Only a few of the banks reported that business record or management capacity is the most significant factor in evaluating loan applications. Most lending institutions continue to use criteria that permit social ties and signals to influence the flow of capital. Another way of looking at this issue is to examine the average value of the ranking for the five criteria. Respondents were asked to rank the five criteria on a scale of one to five-one being the most important and five being the least important. As might be expected, character has the lowest score, although there is some deviation in its ranking. The next most important criteria are cash flow

~m~~dedness

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and Capital Markets: Bank Financing

Table 4.

Ranking of Cirteria Used to Evaluate Loan Applications Mean

standard

Percent

Percent

Deviation

Ranked First

Ranked Last

Character

2.36

1.42

45

9

Cash flow

2.86

1.47

20

20

Collateral

2.96

1.4%

20

25

Business record Management

3.46

1.31

7

32

capacity

3.42

1.10

6

16

Note:

Respondents were asked to rank the five criteria on a scale of one to five, one being most impo&mt and five being least important.

(mean = 2.86) and collateral (mean =I 2.96). The other two criteria have much higher scores and deviate less from the mean, indicating that there was less disagreement about their ranking among the banks. Recent studies suggest that greater involvement in lending policies by boards and shareholders may restrict lending (Boggs, Sorenson, & Isserman, 1988). Twenty-nine percent of the banks reported that shareholders were key operating officers in the bank. The interviews revealed that shareholders who were not key operating officers were also involved in bank operations, usually in making basic policy decisions. Thirty-four percent of the respondents reported that major shareholders approved all large loans and other major financial decisions. Shareholders were less involved in more routine operating decisions. In about 27% of the banks, major shareholders reviewed routine operating decisions, and in lO$%of the banks, they made routine operating decisions. The board of directors was also actively involved in the loan evaluation process in most of the banks. In 92% of the banks, a standing committee designated to review specific credit requests had been organized by the board of directors. Among the banks that had a standing committee, 46% of the commercial and industrial loans were evaluated by the board of directors. Banks also varied in terms of how much responsibility they gave to loan officers. Loan officers in most banks (65%) were authorized to make loans up to $100,000. The descriptive data presented here suggest that signaling activities and networking continue to play important roles in bank lending. Most lenders continue to rely on character as an important consideration, although dere~lation may limit their ability to use this criterion. In the following section, we examine how these criteria and other factors influence lending to local businesses. Determinants of Bank Performance

In this analysis, we focus on three sets of factors (bank and market structure; loan policies and criteria used to evaluate loan applications; and the demand for loans in the community) that influence the loan-to-deposit ratio, acceptance

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Regressions of Bank Pe~ormance on Structural, managerial, and Demand Factors Loan-to-Deposit Ratio

Acceptance Rate

Number of Start-up loans

structure Competition

1.308 L115)

Branch

k.280) -.OlP (-.026)

Size

Mana~~t Collateral Character Board

Demand Per capita income R2 F N=

- 10.480**

.OO8 f.048) -.025 (-.047) ,004s f.298)

-.379 t-.032) -3.117 G.092) .1a4* t.257)

1.801 f.053) 7.628” t.269) .008 1.017)

.034 C.071) -.017 (-042) -3,22YE-04 f-.051)

3.420 k.101) -2.637 k.098) -.041 6.092)

.003** t.250)

4.617E-06 f.028)

.002 L155)

.203 2.042*

.lOl .766*

,146 1.412

73

Notes: Figure in parenthesesis standardizedregressioncoefficient (beta). *p<.1. ** p < 05.

rate, and number of start-up loans. We regress the three measures of bank performance on the structural variables, the management variables, and the measure of demand.6 The loan-to-deposit ratio, indicating how much capital the banks are returning to the community, is a frequently used measure of the overall performance of banks (Table 5).7 The regression analysis indicates that branch banking status, use of character as the most important criteria for evaluating loans, and demand are statistically related to the loan-to-deposit ratio. Branch banks have a 10% lower loan-to-deposit ratio than do independent banks, after controlling for other influences. Banks using character for evaluating loan applications have a 7% higher loan-to-deposit ratio than banks using other criteria, all else being equal. Banks in communities with a high level of demand also tend to have larger loan-to-deposit ratios. Examining the standardized regression coefficients (betas) reveals that branch banking status has the strongest influence on the loan-to-deposit ratio. Thus, the embeddedness/ signaling position receives strong support in this model.

145

Embeddedness and Capita/ Markets: Bank Financing

Another important indicator of bank performance is the acceptance rate among banks. Within our model, bank size is the only variable that has a statistically significant influence on acceptance rate. Bank size is positively related to the acceptance rate, indicating that large banks tend to have a higher acceptance rate than small banks. It should be cautioned that there may be a selectivity problem here-more risky applicants may avoid going to large banks where they believe their chances of obtaining a loan are slim. Again, it would take a different dataset to adequately address this issue. The final measure of performance to be considered is the number of start-up loans. Within the model, bank size is the only variable that is statistically related to the number of start-up loans. Large banks make more start-up loans than small banks. As was suggested earlier, the positive relationship between bank size and number of start-up loans may be due to the overall portfolios and capacity of large banks relative to smah banks. Overall, the analyses of acceptance rates and number of start-up loans support neoclassical economic theory. SUMMARY OF FINDINGS

AND IMPLICATIONS

FOR DEREGULATION

Our analysis identifies the importance of both economic and social factors in the functioning of capital markets. As the embeddedness argument predicts, branch banking status is associated with smaller loan-to-deposit ratios, but it is also associated with higher acceptance rates, as neoclassical economic theory predicts. In the analyses of acceptance rates and the number of start-up loans, neoclassical economic theory predictions regarding the positive effects of bank size also are supported. Large banks are more likely than small banks to make start-up loans and to reject fewer loan applicants. Our findings reinforce the contention of economic sociologists that capital markets are not purely an economic or a sociological phenomenon. Although this study is a relatively limited test of Granovetter’s theory of social embeddedness, we do find support for his argument regarding the role of social influences in the functioning of markets. Social ties shape the allocation of credit in capital markets. Similarly, we find some evidence that signaling is important to the judgments of lenders. Theoretically, this research suggests the need for further investigation in how rational choice and social relations interact in the context of capital markets. The existence of social features within capital markets raises questions about self-regulating markets. Financial market transactions, even a decade after deregulation, are not solely consequences of the internal dynamics of selfregulating market forces. One explanation for this finding is that the banking industry is developing a dualistic structure-a limited number of large, powerful banking organizations operating in regional/national markets and a large number of small, locally oriented financial institutions. We expect this structure to persist to a certain extent, even in the face of further deregulation efforts.

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Regarding the effects of deregulation on financial markets, two issues stand out in these findings. First, much of the literature has attempted to assess whether branch banks encourage greater lending or restrict lending in communities. One source of confusion over this relationship is the attempt to generalize about these effects. One way to interpret our findings and the contradictory literature is that branch banks are inherently neither good nor bad. The branch banking form of organization simply facilitates the flow of capital across space and time. During periods such as the 197Os, when investment in rural areas was favorable, branch banks shifted capital into these areas. The opposite would be true for much of the 1980s and early 199Os, because rural areas have been a less attractive investment location than urban areas. Similarly, we expect branch banks to facilitate investment in rural areas that are growing, such as those on the urban fringe, and to drain capital from those communities that are not growing. Thus, our findings suggest that branch banks more tightly integrate communities into national capital markets. Because the effects of this organizational structure may vary across different communities and over time, our findings should be interpreted in the current context for capital markets, a period when markets are relatively loose and financial institutions are rather conservative in their lending practices. Deregulation may have mixed results-reducing capital availability but improving resources for those able to receive them. A second issue is the importance of bank size in influencing lending patterns. Our data show that large banks tend to have higher acceptance rates (but are more likely to discourage applications) and to make more start-up loans than do small banks. This finding supports many of the claims that large banks would be most beneficial to rural communities (Milkove, 1985). Larger banks may be able to make riskier loans and they tend to have the necessary resources to promote local economic development. Although efforts to deregulate capital markets have produced important structural changes, we find evidence of the continuing importance of social influences in capital markets. Resistance to self-regulating capital markets occurs at both the micro and macro levels. At the micro level, entrepreneurs and small businesses continue to rely heavily on informal sources of credit (Bouman, 1990; Light, 1972). Our field research suggests that informal markets play a minimal role on financing existing businesses but are critical for equity (start-up) financing of businesses. An important question to be addressed in future research is whether businesses turn to informal markets due to their failure in formal markets, or whether informal markets are a preferred form of financing for firms that have extensive social ties. Further work on the link between formal and informal financial markets is needed. At the macro level, we also see the opportunity for even greater social control over financial institutions in the future. The Clinton administration recently has become concerned with collateral-based lending, which it believes restricts

Embeddedness

and Capital

Markets:

Bank Financing

147

access to capital. The administration has encouraged the banking industry to increase character-based lending. Our analysis suggests that these policy changes will help retain capital in the local community but will do little to create new businesses in small towns. Community organizations are countering the effects of deregulation through community reinvestment challenges and by establishing new communityoriented institutions, such as the South Shore Bank in Chicago. Further consolidation of the industry and deregulation will be predicated on lending institutions demonstrating that they are meeting their social responsibilities. Community organizations are using deregulation as a mechanism to inject greater social control over capital markets. These developments tend to support Polanyi’s characterization of the double movement in market society, the simultaneous push for self-regulation and social protection. Acknowledgments:

This material is based upon work supported by the Cooperative State Research Service, U.S. Department of Agriculture under Agreement No. 90-34229-5206. Any opinion, findings, conclusions, or recommendations expressed in this publication are those of the authors and do not necessarily reflect the view of the U.S. Department of Agriculture. The authors appreciate the assistance of Beth Fletcher, David Lewis, and Candee Car&ma, and the comments of Walter Peacock, Hassan Elnajjar, Becky Winders, and Debbie Cowell.

NOTES 1. 2.

3.

4.

For economic analyses of the effects of branching and regulation, see Alhadeff (1954), Guttentag and Herman (1967), and Benston (1973). A branch bank is defined as an establishment that is owned by a larger company. There are various organizational structures in the United States, including independent banks, bank holding companies, and branch banks. Independent banks are totally autonomous; other forms of organizing banks are based on the parent corporation exerting some control over their branch operations. Some research in minority communities suggests, however, that the demand for credit is, to a great degree, inelastic in these settings (Dominguez, 1976). From the banker’s standpoint, however, an undiversified economy and low economic growth restrict the ability to increase lending. We stratified our sample on the basis of these categories. Agricultural-dependent counties were defined as counties that derived more than 20% of their income from farming over the 19751979 period. Twenty percent of Georgia’s nonmetropolitan counties are classified by the Economic Research Service (ERS) as agriculturaldependent. We selected five (20% of our sample) agricultural-dependent counties for inclusion in our sample. Manufacturingdependent counties are defined as having more than 30% of their income from manufacturing. Forty percent of Georgia counties are considered dependent on manufacturing. Ten counties, or 4OYcof our sample, are manufacturing-dependent. Government-specialized counties derive 25% or more of their income from government employment. Fourteen Georgia counties, about 9% of the counties in the state, are classified as government-specialized counties. Two counties, or 8% of our sample, are government-specialized counties. Retirement settlement counties are defined as having a 15% or greater in-migration of persons 60 years or older between 1970 and 1980. Twenty-three (14% of Georgia’s nonmetropolitan counties) are

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5.

6. 7.

Vol. 24/No. l/l 995

considered retirement communities. We selected three retirement settlement counties (12% of the sample) for inclusion. ERS defines persistent poverty counties as having per capita incomes in the bottom quintile of all U.S. counties in 1950,1959, 1969, and 1979. Seventeen percent of Georgia’s nonmetropolitan counties are classified persistent poverty counties. Four counties (16% of our sample) were selected for inclusion in this study. One additional county which was unclassified was included in the sample. When measuring the size of bank, we are considering the establishment rather than the &XI. Thus, we use the number of employees in a branch rather than the total number of employees in the bank. We conducted regression diagnostics and found no multicollinearity problems. For criticism of this measure, however, see Dunham (1986).

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