Savings and Cooperative banks: Social Approach to Credit Rationing docx

1Paper submitted to the Savings Banks Academic Award 2008 Savings and Cooperative banks: Social Approach to Credit Rationing Nazik Beishenaly PhD student at the Grenoble-II University

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Paper submitted to the

Savings Banks Academic Award 2008

Savings and Cooperative banks:

Social Approach to Credit Rationing

Nazik Beishenaly PhD student at the Grenoble-II University (France) &

at the National University of Kyrgyzstan

Adress: 64, av Prekelinden,

1200 Woluwé St Lambert

Belgium E-mail: nazik_beishenaly@yahoo.com

December, 2007

to traditional and relational approaches which only remotely describe cooperative and savings banks reality Social approach seems not only to better describe the relationship with their

members but also appears to be positive constraint that the cooperative and savings banks’

organizational structure puts on their performance In fact the confusion between customer functions of cooperative banks’ members and public interest assignment of most European savings banks make clear that these banking institutions’ finality is to offer services

owner-to the community Loans owner-to SME reveal this finality

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Introduction

Despite the fact that savings banks vary significantly from country to country in their structures and the roles they play in their local markets, savings banks in Europe are progressively becoming universal banks The question arises about the particularity of savings banks with this evolution: if they still have a separate identity or if “it is already diluted in wide institutional variety on one hand and in universalized operations on the other” (Wysocki, 1995, p.27)1

According to the European Savings Bank Group, today’s savings banks stand out first and

foremost for their “close local and regional ties and proximity, the will and vocation for socially responsible behaviour and a comprehensive range of financial services for private and corporate customers with a special focus on small and medium- sized enterprises” (ESBG&WSBI, 2006, p 35) The last statement presents several questions in view: can savings banks’ focus on SMEs secure their particular position in banking industry? Why savings banks would be a better fit when it comes to supplying credit to “risky” borrowers as compared to commercial banks? How do they protect themselves from hazards associated with lending to micro and small enterprises?

In our paper we argue that savings but also co-operative banks are the most efficient banking institutions offering credit to SMEs as a result of better capacity to reduce credit-rationing problem

1 In Brück et al (1995)

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It is a well-known fact that SMEs are unanimously considered by economic researchers and policy makers as a group most exposed to credit rationing problem This opinion is traditionally

explained by information asymmetry within new-Keynesian theoretical framework (Stiglitz and

Weiss, 1981) However, in this work we adopted a different approach, the one based on

post-Keynesian anticipation asymmetry (Wolfson, 1996) We will discuss both theories and their

impact on “savings and cooperative banks- SMEs” relationship in the first part Our study is based on the presumption that the capacity of banking institution to reduce credit-rationing problem would not only foster access to finance for SMEs, but it can also represent a competitive advantage for the bank Therefore in the second part of this paper we will analyze the factors of lenders’ anticipations that affect credit rationing Our hypothesis is that these factors are specific to savings and cooperative banks and thus can be considered as intrinsic forms of competitive advantage In the new environment where savings and cooperative banks have become important actors of European banking industry perfectly capable to compete with commercial banking, this advantage can serve as a crucial feature distinguishing them from other banking institutions

Credit rationing theory

Traditionally credit-rationing problem is represented within new-Keynesian (Stiglitz and Weiss, 1981) analytical framework based on asymmetrical information The latter explains why economic agents have conflicting relations where borrowers mislead lenders, obliging them to take measures such as credit rationing We consider that interests of the bank and the borrowers are not always conflicting, especially in case of cooperative and savings banks, given their ownership structure and historical background This fact allows us to employ alternative post-

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Keynesian (Wolfson, 1996) framework where it is believed that uncertainty does not allow

overcoming informational opacity in ultimate terms Thus instead of asymmetry of information one can think in terms of asymmetry of anticipation In fact cooperative and savings banks’

lending activities are characterized by their will to approximate their anticipations to those of their borrowers

Moreover, according to new-Keynesian approach of exogenous money, banking institutions are

conceptualized as pure financial intermediaries, while in post-Keynesian endogenous money perspective they create money by making loans Given the fact that in Europe cooperative and savings banks are primary credit organizations(OCDE, 2005; Banque de France, 2006), their

role is to some extent crucial as compared to commercial banks However in present paper we focus mostly on ‘lender-borrower’ fragment of money-and-credit theoretical debate between new- and post- Keynesian authors 2

Credit rationing - a consequence of asymmetric information?

According to Stiglitz and Weiss (1981), credit rationing refers to a situation where within a group of loan applicants with equal characteristics, some of them receive a loan and some do not even if they offer to pay a higher interest rate Still, some individuals could obtain a loan

2 Stiglitz J.E., Weiss A (1981) “Credit Rationing in Market with Imperfect Information” in New Keynesian Economics, v.2:

Coordination Failures and Real Rigidities, ed by Mankiw N.G., Romer D., The MIT Press, Cambridge

Wolfson M H (1996) “A Post Keynesian theory of credit rationing”, Journal of Post Keynesian Economics,

Armonk, spring, vol 18, iss 3

Asymmetric information, key concept of New Keynesian approach, corresponds to the situation where the borrower knows the exact distribution of the probability of success of his investment project, but not the lender In the situation where available offer cannot satisfy the demand for credit, bank will tend to raise interest rate in order to equilibrate the market However, this increase will backfire by attracting risky projects as a result of the operation In fact,

3 “What ensures that the number of individuals certified to be credit worthy, combined with those with cash

resources, generates a demand for current resources equal to current supplies?… The answer provided by

traditional micro-economic analysis is simple: if there is an excess demand for current resources, the real rate of interest will rise: as this happens, the demand for credit, i.e., the number of individuals seeking certification from the banking institutions is reduced until demand equals supply at full employment for current resources

Similarly, potential borrowers with high expected yield projects will bid more for resources, resulting in an

efficient allocation of resources We now argue that, in economies characterized by information imperfections the price system may well not serve the information-equilibrating role assigned to it by conventional theory ” (Stiglitz et Weiss 1990, p 101)

…or a consequence of asymmetric anticipations?

Post-Keynesian representation of credit rationing problem (Wolfson, 1996, Isenberg, 1998, Dow, 1998), which was elaborated upon based on the theory of endogenous money, differs and criticizes the previous theory It cannot be accepted that information on success of the project

exists and is known to one group of agents (borrowers) and is concealed from the other

(lenders) This assumption would be in opposition with the notion of fundamental uncertainty

of Keynes where the future cannot be known at any conditions Given that economic system is

under continuous structural change, uncertainty does not allow utilizing certain methods that would help to predict the issue of investment projects (Minsky, 1974; Basu, 2003) Therefore, borrower’s desire to borrow and to finance new investment “arises jointly from optimism about returns to the real investment and a need for financial capital, while lenders’ terms depend on the optimism of both potential lenders and wealth-holders” (Chick and Dow, 1988)

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Credit rationing appears whenever “bank refuses to lend to particular borrower despite his will

to pay higher interest rate” (Wolfson, 1996, p 463) This definition results from distinction

made by Wolfson (1996) between notional demand (all demand in economy for bank credit) and effective demand (demand of borrowers considered creditworthy) Banks produce credit in

response to the effective demand, while the difference between notional and effective demand represents rationed part of credit demands Asymmetry of information thus does not play

crucial role when efforts are made to explain credit rationing In fact ex ante asymmetry, as

adverse selection and incentive effect, are not regarded as decisive factors of credit rationing However, the concept of asymmetry of information as such, is not contradictory to this

analysis: in case where the relationship between bank and its customers is deficient, ex post asymmetry as moral hazard or opportunism can emerge describing the situation of voluntary

risks (Lavoie, 1992)

Bank can refuse credit for two main reasons: 1 because bank does not believe in successful issue of the project at any interest rate even if it is not constrained by the money supply limits; 2.because potential borrower does not satisfy bank’s conditions (Lavoie, 1992) In both cases,

credit demand is not considered effective Only demand judged as effective can determine the

volume of bank credit In post-Keynesian perspective, bank appears to be the one who decides the volume of credit in economy in contrast to its traditional representation as a simple financial intermediary

The bank’s choice between effective demand and rationing is function of mutual knowledge between bank and its customer (Dow, 1998) The concept of knowledge is thus opposed to the

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one of information which corresponds to the set of empirical data, while knowledge describes a more dynamic process Thus the volume of credit supply reflects the state of knowledge between borrowers and lenders (Dow, 1998)

The problem of credit rationing emerges consequently from anticipations asymmetry (Wolfson,

1996), which is legitimate with regard to the concept of uncertainty These anticipations correspond to the differences in perception of the future by different groups of agents In fact, lenders and borrowers can have different anticipations of the success of the project on the grounds of the same available information Investment projects are therefore double-constrained by the choices of both borrowers and lenders Credit rationing results then from the situation where projects are considered successful by borrowers but not by banks In fact, borrower might believe in success of his project but it does not connote the project’s successful realization

The level of credit rationing depends on bank’s subjective evaluation criteria based on its confidence and not only on probability calculations: « The state of long-term expectation, upon which our decision are based, does not solely depend, therefore, on the most probable forecast

we can make It also depends on the confidence with which we make this forecast-on how highly we rate the likelihood of our best forecast turning out quite wrong” (Keynes, 1936, p 148) Bank’s confidence is related therefore to the asymmetric anticipations, which can modify the level of credit rationing At some point of confidence level, bank tolerates risk and grants credit, but once the limit of its confidence is touched upon, credit rationing takes place (Wolfson, 1996)

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In resume, for New Keynesians asymmetrical information reflects the situation of unequal distribution of information, which could benefit from a more efficient allocation of resources if client relations would be better developed In fact, transparency of information would let banks select good borrowers In Post Keynesian analysis, even with transparent information uncertainty excludes any attempt to know the future Only concordant anticipations can reduce the problem of credit rationing We can conclude this assumption by the following logical statements: 1 good “lender-borrower” relationship makes it possible to develop mutual knowledge; 2 mutual knowledge facilitates establishment of confidence; 3 confidence can reduce asymmetry of anticipations and thus credit rationing itself

Common conclusion to both approaches is the importance that needs to be attached to the relationship between bank and its customer as the decisive factor of reducing credit rationing problem However, there is a difference in the approach to the banks’ customers: information asymmetry supposes that borrowers continuously seek to deceive lenders while the practice of relational banking would help the financial institution to monitor and to distinguish “good” borrowers Anticipation asymmetry does not consider borrowers as a group with interests opposite to lenders’ since even their honest behaviour does not prevent from their “nạve” anticipation

“Fringe of unsatisfied borrowers”: micro, small and medium enterprises

As stated in recent OECD’s study on SMEs’ financing gap, policy makers are aware of great importance of funding and acknowledge that the lack of finance in appropriate forms may be serious barrier to the development of this sector (OECD, 2006) While bank credit programs

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1 The category of micro, small and medium-sized enterprises (SMEs) is made up of enterprises which employ fewer than 250 persons and which have an annual turnover not exceeding EUR 50 million, and/or an annual

balance sheet total not exceeding EUR 43 million

2 Within the SME category, a small enterprise is defined as an enterprise which employs fewer than 50 persons and whose annual turnover and/or annual balance sheet total does not exceed EUR 10 million

3 Within the SME category, a microenterprise is defined as an enterprise which employs fewer than 10 persons and whose annual turnover and/or annual balance sheet total does not exceed EUR 2 million

“Commission Recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises”,

Official Journal of the European Union n L124/36, 20 May, 2003

pays an amount of money corresponding to the price of the merchandise A contrario, on the

loan market, vendor does not receive his payment immediately Hence he needs to evaluate the buyer’s repayment capacity Banks in their objective of maximizing their profit will naturally refuse projects offering low benefits or judged risky both in terms of creditworthiness or liquidity

It is often argued that credit rationing would be reduced if long term and personalized relationship exists between banks and enterprises (Diamond, 1991; Nakamura, 1999) SME would have better access to finance: “the smaller the enterprise, the more important and the higher the value of the information obtained by the banks within their commercial relationship

In these conditions, the existence of dynamic client relations does not remove credit rationing but let the banks distinguish and be selective towards bad risks only” (Nakamura, 1999)

Relationship banking is developed as alternative/complementary practice to the transactional approach In fact, relational approach would provide “soft” information based on qualitative

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aspects such as personality of borrower, etc., while transactional one deals with “hard” information concerning financial data, payments operations’ histories, etc (Berger and Udell, 2002) If transactional approach reflects brief and inconsistent interactions, relational banking

is in line with long-term strategy of the bank which not only helps to obtain supplementary data

on the creditworthiness of the borrower but also to monitor him Moreover some authors (Boot 2000; Ongena and Smith, 2000) argue that relational approach along with appropriate informational distance jointly offer to the bank access to confidential information unavailable

to other financial intermediaries The question of distance between bank and its borrowers has been identified as important, however equally neglected determinant of credit rationing (Petersen, Rajan, 2002; Degryse, Ongena, 2005) The bank therefore has potentially lucrative advantage of exploiting his monopolistic position with the customer Relational banking is seen

as a pragmatic solution to the losses of profit from operations with “good” borrowers rationed wrongly

Alternatively we suggest that savings and cooperative banks already possess tools which can serve to reduce credit rationing for the benefit of both lenders and borrowers In fact cooperative and savings banks where owners are also borrowers (ex., cooperative banks) or the owner is the State (ex., public savings banks) do not encounter conflicts between lending institution and beneficiaries typical of other banks Summarizing it, both asymmetries related to the information and anticipation will be reduced: generally speaking, borrowers do not have opposite interests with their cooperative or savings bank so they will not try to mislead it on permanent basis; cooperative or savings banks are aware of this and will ensure more responsibility in credit demand treatment