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Small Business and Big Firm: A Love Story?

Are small businesses benefiting from long-term relationships with big financial firms? While this seems to be the general belief, 1994 research conducted by Petersen and Rajan suggests the answer to this question might be more complex than it seems.

Small businesses tend to rely on large financial firms to provide them with a large number of services. They tend to turn to the same financial firms for lending money, believing that the long-term relationship will provide them with better lending rates. The research shows that although the long-term relationships between small business and big firms cause a greater availability of finances for the small business, the lending rates are unaffected.

The longer the relationship between the small business and the big firm, the more financial services the small business acquires from the big firm. In addition, the longer the relationship between the sides, the higher the probability of the small business concentrating all its borrowing from the one lender.

The long-term relationship between the two sides reduces the risk taken by the big firm. As the big firm provides more financial services to the small business over time, the big firm is exposed to more information about the small business, and therefore the risk taken by lending the small business money is reduced.

Although the long-term relationship does not reduce the lending rates for the small business, it certainly doesn’t worsen them in any way. The findings of the research do not suggest that borrowing money from a number of different lenders assures lower rates than concentrating all money borrowing from one lender.

The researchers conclude that although the long-term relationship between a small business and a big financial firm does not improve lending rates for the small business, the relationship is overall mutually beneficial. The long relationship benefits the small business by raising its access to finances, and the relationship benefits the big firm in that it provides more financial services and reduces the risk taken by lending money to a small business.

Source: Petersen, Mitchell A, and Raghuram G Rajan. “The Effect of Credit Market Competition on Lending Relationships.” Quarterly Journal of Economics, MIT Press. 110.2 (1994): 407–43. Web. 8 Mar. 2013.

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