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Hidden Gems and Borrowers with Dirty Secrets

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Hidden Gems and Borrowers with Dirty Secrets

Investment in Soft Information, Borrower Self-Selection and Competition

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Small businesses should bank with relationship-focused institutions.

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8

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  • Innovative

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A bank’s success hinges on figuring out whom to lend to and at what rate. While transaction banks make this judgment using hard numbers, relationship banks get to know their clients and their businesses, and accept soft data that could conceal either “hidden gems” or “dirty little secrets.” Reint Gropp, Christian Gruendl and Andre Guettler examine which strategy pays off. getAbstract recommends their fresh analysis to borrowers seeking the best terms, bank executives wishing to optimize lending, and regulators and politicians concerned with small business growth.

Summary

Banks determine borrowers’ creditworthiness by assessing a mix of financial data and “soft information” – subjective information that doesn’t appear on a borrower’s accounting statements but that alter the bank’s perception of the borrower’s risk. Typically, small banks rely to a greater extent on soft information and become relationship banks. Large banks tend to focus more heavily on financial data and become transaction banks.

Data from the German Savings Banks Association illustrate the effect of soft information on lending. In 2002, all its member banks began using a uniform...

About the Authors

Reint Gropp holds the chair of sustainable banking and finance at Goethe University in Frankfurt. Christian Gruendl and Andre Guettler work at the finance department at the European Business School.

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