Journal of Economic Policy Reform Vol. 10, No.

4, 325333, December 2007

Bank Loan Behavior and Credit Information Sharing: An Insight from Measurement Costs
XUEHUI HE* & YIMING WANG**
*Hunan University, PRC, **Peking University, PRC
xuehuihe@126.com XuehuiHe Francis 0 400000December 10 2007 OriginalofFrancis 1748-7870 (print)/1748-7889 Journal&Article 2007 10.1080/17487870701554315(online) GPRE_A_255290.sgm Taylor andEconomic Policy Reform

ABSTRACT We find that the measurement cost of creditworthiness is important when considering the behavior of banks. A set of credit infrastructures, i.e. a credit rating system, will help to increase the incentive of the banks to make unsecured credit loans, and thus help financial development. However, since the credit information sharing system is a kind of public good, it will not come into being endogenously in most cases without the driving force of the government. KEY WORDS: Banking credit, measurement cost, credit record JEL CODES: D8, G14, G21

1. Introduction Banking credit is an important engine of economic growth. However, bank loan behavior differs across countries and with stages of development. In developed countries, there are many unsecured credit loans where the lender can decide to lend or not based solely on the applicants credit records. However, in China, state-owned commercial banks have made loans on the basis of loan inspections and reviews made by loan officers. Today, our banks in China prefer guaranteed loans, collateralized and secured loans. There should be inherent economic laws and reasons which explain these different banking loan behaviors. Banks live on interest margins. So there are two bases for bank profits: (1) the interest margin and (2) the volume of deposits and loans. Taken together, these must cover the banks overheads and operating costs.
Correspondence Address: Xuehui He, College of Finance, Hunan University, Changsha, Hunan 410079, China. Tel: 86-731-8684849; Fax: 86-731-8684772; Email: xuehuihe @126.com
ISSN 17487870 Print/ISSN 17487889 Online/07/040325-09 2007 Taylor & Francis DOI: 10.1080/17487870701554315

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From their deposits, banks make loans in order to be profitable the larger the loan, the better. However, credit rationing is common, resulting in deposit surpluses. This is contrary to profit maximization. Why does credit rationing occur? Small and medium size enterprises have high default rates. Farmers in rural areas have little collateral and are credit risks too. Traditional theory often blames the problem on asymmetric information the potential borrower knowing more about her creditworthiness than the potential lender. Hence, a reasonable bank would try to eliminate asymmetric information by incurring search costs to acquire reliable information on the borrower requesting a loan. We note the following: small and medium-sized enterprises financing problems are not common in all countries, which means that banks dont have a natural preference for big companies; competitive pressure to survive will push banks to evaluate the creditworthiness of the potential borrower in order to make more loans; and even strong companies with good creditworthiness also have trouble getting loans. Why are more loans not made in China, despite the good credit risk of borrowers? Measurement cost provides an insight into this problem (Barzel, 1982; Cheung, 1983; 2002; Jiang, 2005). Typically, banks in China investigate the borrower before granting the loan this process is called loan inspection. In essence, loan inspection is a measurement of the borrowers economic status, and it has a cost we will call the measurement cost. If the expected measurement cost from the loan inspection process exceeds the banks expected margin, subtracting all other expenses, then the bank will not issue the loan. Consequently, a credit reporting institution that can efficiently decrease the measurement cost would increase the size of the credit market and profitably solve the enterprises financing problems. We compare different measurement means used by banks, and then consider how an efficient measurement institution comes into being. The rest of the paper is organized as follows: Section 2 makes a preliminary analysis on measurement techniques and their respective cost in extending bank credit. Section 3 shows the importance of measurement cost in the loan decision-making process; Section 4 reviews the credit investigation systems in different countries; and finally, Section 5 concludes. 2. Credit Measurement Means and Measurement Cost In banking credit, the key step is to identify the borrowers ability and willingness to repay to identify their creditworthiness. We use creditworthiness to represent the repayment probability. If a creditworthiness evaluation can be done precisely, the bank can set the corresponding interest rates with respect to the creditworthiness. If both sides agree on the interest rate, the loan can be made. In general, the credit measurement techniques are as follows:

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direct measurement: this is the traditional method of credit measurement used by Chinese banks. It is based on the banks own investigation and analysis; guarantee measurement: in this approach, the bank makes loans with a creditworthy third-party guarantee in case the borrower defaults; collateral measurement: here, the bank works like a pawnshop or escrow account. It takes the borrowers collateral or pledges, and the bank identifies the collaterals property rights and market value to make the loan decision; credit record measurement: the bank accesses credit records from a credit ranking system, and evaluate the borrowers creditworthiness by her records. Obviously, banks could choose different measurement means, and the key factor is the measurement cost. Direct measurement depends on the investigation of loan officers instead of another agencys credit information, and has been used for a long time by Chinas state-owned commercial banks. In the early 1990s, many banks even built up their own credit rating institution to evaluate the clients creditworthiness. But the credit rating system did not last long because of its high measurement costs employee expenses, designing rating rules, and especially the supervision cost of preventing collusion between loan officers and the borrower. Third party guarantees and collateral measurement proved less costly. They are easier to implement and cost less by substituting third-party measurement for borrower assessment. The guarantors are always institutions or persons who have a good credit reputation and the ability to repay the loan. Generally, in rural credit, the guarantors are important figures, such as village officials or self-employed business people, who have the capacity to guarantee small loans; in the case of large-scale enterprise loans, the guarantors are mostly listed companies. Their joint liabilities are under public supervision, which increases their default cost. With collateral, loans are guaranteed by collateral or pledges whose value exceeds the amount of the loan. Theoretically, the value of the collateral has risk produced by the volatility of its market value, but this is customarily relatively low. Although this approach is ideal for its lower cost and risk, it cannot be widely used since there are a limited number of customers, particularly SMEs and farmers, who can offer collateral. The cost of credit record measurement is low. The lender can directly check borrowers credit records, including her basic status, loan records, default records and credit application records, which are vital for the judgment of whether the borrower can repay on time. Banks can save a lot of measurement cost through this system and make loans without collateral if the borrowers credit records are good. Direct measurement seems to cost the most and checking credit ratings seems to cost the least. Third party guarantees and collateral measurement lie in the middle, but their usage is narrow. All developed countries have established advanced credit rating systems. This will be a natural evolution in China.

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3. Why Measurement Cost Matters In the customer review process, the bank has to incur measurement cost. The loan inspection techniques are: direct loan measurement, requesting securities or collateral, or accessing the borrowers credit report. Each technique has its own cost. The loan decision-making process has two steps. The first decision is whether to incur the measurement cost. Once the cost is paid, it becomes a sunk cost; the second step is to decide whether to issue the loan on the basis of the applicants creditworthiness. Assume that the potential borrowers investment project i requires one unit of capital. The return from the project is R in the good state with the probability pi, or 0 in the bad state with the probability 1 pi. Also assume that all projects have the same expected return piR = R , but different projects have different levels of risk larger pi means lower project risk and banks prefer such projects. Therefore, the banks loan review is to identify the probability of success pi. Given the firms own-invested funds, W, and the average opportunity cost of such funds , the amount of the loan would be B = 1 W at the interest rate r. The firm would apply for the loan only if the project is profitable. That is pi [R (1 + r)(1 W )] (1 + )W . Thus, we have: pi R (1 + )W p (1 + r)(1 W ) (1)

This inequality implies that the probability of success pi must be no bigger than p for the firm that has applied for a loan. Assume that the probability of success cannot be directly observed by the bank, but the firm itself knows it. So knowledge of pi is asymmetric between the bank and the firm. The bank needs to investigate the firms creditworthiness its financial status or credit records and thus ascertain the firms ability and willingness to repay the loan. The means of measurement can be any of the three methods discussed above. However, the bank knows the probability distribution of the financial ratios, yi, conditional on the probability pi, and its density function is f(yi /pi). Furthermore, if we denote the measurement cost as k, we can assume that it obeys the uniform distribution

pi, which means pi can be reflected in yi. But the variance of yi decreases as k increases. We assume that the more measurement cost the bank incurs, the more precisely it understands yi. When the measurement cost is 0, the bank would have the poorest understanding of the project, and the variance would be the largest. For that case, yi obeys the uniform distribution [pi , pi + ]. According to the Bayesian Law, the probability of success inferred by the bank would be:

s s pim - 1 + k , pim + 1 + k . Here the mean of yi increases with the probability

Bank Loan Behavior and Credit Information Sharing g(pi / yi ) = f (yi / pi ) f (pi )

329 (2)

f (yi / pi ) f (pi )dpi

The banks return would be: rB k with the probability pi; and (B + k) with probability 1 pi. So, the expected bank profit is: E( / y, k) = (rB k)pi g(pi / yi , k)dpi + ( B k)(1 pi )g(pi / yi , k)dpi
0 0 p p

= (1 + r)B pi g(pi / yi , k)dpi (B + k) g(pi / yi , k)dpi

0 0

(3)

The bank would inspect the loan only if the expected net return is positive. That is: (1 + r)B B+k

0 g(pi / yi , k)dpi = 0 f (yi / pi )f (pi )dpi p p 0 pi g(pi / yi , k)dpi 0 pi f (yi / pi )f (pi )dpi

(4)

Suppose the prior probability of pi is a constant c, equation (4) would be: (1 + r)B B+k That is: (1 + r)B 2(B + k) p (6)

0 k 2 dpi
pi k 2 dpi

2 p

(5)

From inequality (6), we have two propositions. Proposition 1: Given the amount of loan B, the lower the measurement cost is, the higher the banks incentive to extending loans is and the lower the interest rate the bank will charge. Proof: Given B, as p is a constant, the critical value on the right hand side for inequality (6) is a function of measurement cost k, and is positively correlated with k. Clearly, with a small k, the critical value is also small and therefore the probability for the inequality (6) to hold increases. This means the probability that the bank makes the loan increases. By the same logic, with a small k, a small critical value on the right hand side, a smaller interest rate r can make the inequality hold. QED

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Proposition 2: The larger the proportion the firms own funds W takes in the project, the higher the incentive the bank has to extend the loan. Proof: Combining equation (1) with inequality (6), we have: 2(1 W + k) 1 R (1 + )W Differentiating the left hand side (LHS) with respect to W: dLHS 2[(1 + k)(1 + ) R ] = dW [R (1 + )W ]2 For B + W = 1, the numerator of formula (8) can be written as 2[(B + W + k)(1 + ) R ], where (B + W + k) is the total investment the project requires in the form of banking loans. The opportunity cost would be (B + W + k)(1 + ). For the no-arbitrage principle of the investment project, we have (B + W + k)(1 + ), R , therefore the first-order derivative formula (8) is negative. Consequently, with a large W, the LHS would be small, which means the probability of inequality (7) holding increases. Accordingly, so does the probability of the bank making the loan. QED Proposition 2 reaches the same conclusion in the economics of information. While the information of the project risk is asymmetric between the bank and the firm, if the risk-level is low, the borrower may choose a high proportion of self-invested funds as a signal to differentiate its own project from those with high risk-levels. If a project is financed wholly by bank loans, it is inherently a risky one. Issuing no down payment loans increases default risk. Proposition 1 is the key conclusion of the paper, and it deals with the means of measurement. It has two empirical implications. It tells us that higher measurement cost techniques will eventually be substituted by lower measurement ones. (A) Adopting credit measurement, banks are more willing to make loans which will enlarge the size of the credit market. This is in accordance with the empirical finding of Jappelli and Pagano (2000a). We call this the loan size effect. (B) Adopting credit measurement, the social financing cost is decreased. Firstly, the decrease of measurement cost reduces the banks operating cost, which enables it to reduce the loan interest rate. Secondly, with more accurate measurement, banks can price the risk more precisely, which in turn eliminates informational rents and risk premia. Both tend to reduce the lending interest rate (Jappelli and Pagano, 2000b). We call this effect the cost of capital effect. Credit ratings would be, in principle, the first choice for a banking system. It can help with banks loan decision-making, as well as alleviating credit (8) (7)

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rationing and the enterprises financing problem by reducing asymmetric information. 4. Why Cant Credit Information Sharing Come into Spontaneous Existence in Some Cases? Most developed countries have established credit ratings systems. However, it is worth considering why banks in China have instead rationally chosen a collateral system. Why cant credit ratings come into being spontaneously in China? In essence, the credit reporting system is a kind of credit information sharing. Every bank should provide its customers credit information to the system. Credit information and rating is a kind of public good. However, public goods are not excludable in use. When a bank provides credit information, other banks can use it freely at the same time. The problem is the free-riding motive that public goods users always have. Each bank expects other banks to provide information for the system, but the bank itself would be a beneficiary instead of an information supplier. Therefore, there will be few providers of public goods. To solve the problem, economists often suggest that public goods be provided by the government. In Europe, the credit reporting systems were mostly started by governments. In America, the credit reporting system came into being spontaneously, and is mainly run by private credit reporting agencies, such as Standard and Poors, Moodys, and Fitch. To understand these differences, consider the credit reporting mechanism as a whole. Assume the supply of credit funds is one unit, and the average deposit interest rate is rD and the average loan rate is rL. Consider collateral versus credit ratings. Assume the amount of credit funds requested by applicants with collateral takes the proportion and the measurement cost of credit ratings is kc while the measurement cost of collateral is ks. If the applicants with collateral get the loan first, then after checking the collateral, the bank will issue the loan without additional requirements due to its low risk. The credit loan applicants, who cannot offer any collateral, will compete for the rest of the credit funds, (1) units. Without a credit sharing system, all loans will be made on the basis of collateral, and no credit loans will be made. The total profit of the banking industry will be:

nc = rL rD ks

(9)

If the loan applicants as a whole cannot provide enough collateral, namely <1, there will be a deposit surplus, such as in China. If a credit rating system exists, the applicants with collateral will also get the loan first; then the rest of the funds can be provided to the credit loan applicants based on their credit rating. If the approval ratio of credit loans is , bank profits will be:

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1 p c = t (rL - rD - ks ) + (1 - t )(rL - rD ) - kc d
So the potential addition to profits of the credit investigation system is: 1 c nc = (1 ) rL kc

(10)

(11)

If the potential profit calculated above exceeds the costs of operating a public ratings system, the banks will have an incentive to share credit information. We can conclude the following proposition from equation (11). Proposition 3: The higher the proportion, , of the amount of loans made to applicants with collateral, the lower the incentive of the banks to share credit information; the lower the approval ratio of the credit loans is, and the lower the banks incentive to share credit information. The proposition verifies the previous prediction. If most applicants can provide enough collateral, then the banks may not need to share credit information. If there is little honesty and faith in the culture, then the approval ratio of credit loans would be low and banks may not have the incentives to establish a credit sharing system. 5. Conclusion By considering the measurement cost of different means of loan inspection, we reach some sensible conclusions. Firstly, creditworthiness measurement cost can affect the incentive of the banks to make loans, as well as the loan interest rates. Credit ratings thus have credit size effects and cost of capital effects. If the applicants with collateral receive most of the loans, the endogenous incentive of banks to share credit information is low. Similarly, if the approval rate of credit loans is low, the incentive of the banks to share credit information is also low. Additionally, we have verified a classical conclusion: a high proportion of self-owned funds in an investment is a signal of low risk, and therefore this raises the likelihood of loan approval. Acknowledgements We are pleased to acknowledge the generous research support from Project 985 Globalization and Foreign Trade, and the Credit Research Center, Hunan University. We also wish to thank an anonymous referee for helpful suggestions.

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Barzel, Y. (1982) Measurement cost and the organization of markets, Journal of Law and Economics, 25(1), pp. 2748. Cheung, S. (1983) The contractual nature of the firm, Journal of Law and Economics, 26(1), pp. 121. Cheung, S. N. S. (2002) The Choice of Institutions (Hong Kong: Hua qian shu Press). He, X. & Wang, Y. (2007) Developing warehouse receipts systems: a new approach to rural financial reform, The Theory and Practice of Finance and Economics, 28(2), pp. 27. Jappelli, T. & Pagano, M. (2000a) Information Sharing, Lending and Defaults: Cross-Country Evidence, CSEF Working Paper 22. Jappelli, T. & Pagano, M. (2000b) Information Sharing in Credit Markets: A Survey, CSEF Working Paper 36.