A re-examination of the role of relationships in the loan-granting process

We reexamine the role of relationships in the loan granting process overall. A practical implication emerging from the classical studies on the role of relationships in credit rationing is that good relationships between a borrower and his lender should, in fact, work to lower the interest rate charged to the borrower. We test this implication in our paper using a robust sample selection methodology that explicitly accounts for the entire fabric of the loan granting process, including a borrower’s decision to apply to the bank for a loan (or not), whether a bank approves the application for a loan (or not) and the loan rate it chooses for the borrower – all within a sequential, but unified, framework. We also examine if relationships have a distinct role in the different stages of the loan process. Our model is also able to explicitly account for discouraged borrowers (i.e., those who do not apply for loans because they believe they will be rejected) – an issue not tackled in the extant literature. We find that that relationships matter only in the first and second stages of the loan process, i.e., a borrower’s decision whether to apply for a loan, and in the loan approval/rejection decision by the financial institution. But relationships are not important in determining the loan rate associated with the approved loan once the sequential stages of the loan process are accounted for. Our conclusions are robust to the nature of the loans (i.e., collateralized versus uncollateralized), as well as to the nature of the borrowers (i.e., individual families as well as small businesses).