CHAPTER 2; LITERATURE REVIEW
This chapter covers the theoretical literature and as well as empirical literature and also the chapter will be highlighting the impact of relationship lending on banks profitability. The following will be discussed in this chapter;
2.1 THEORITICAL REVIEW
2.1.1WAYS OF HARNESSING RELATIONSHIP LENDING
Relationship lending refers to a common practice in credit financing where a corporation has close ties to a financial institution. Relationship lending helps to reduce asymmetric information which potentially creates benefits to borrowers. Asymmetric information is a situation where there is imperfect knowledge. It occurs where one party has different information to another. Asymmetric information can lead to adverse selection, incomplete markets and is a type of market failure. Adverse selection refers generally to a situation where sellers have information that buyers do not have or vice versa about some aspect of product or service quality (Thakor 1994).
Relationship lending is mechanism that allows to get more informative credit contracting decisions based on a better exchange of information, and also increase the availability of credit to information-sensitive borrowers (Berlin and Mester, 1992). Banks has a variety of ways in which they establish profitable relationships with their customers. Some of the ways are as established below;
Communication; is a process whereby information is enclosed in package and is channeled and imparted by a sender to a receiver via some medium (Stein 2002). Banks establish good relationship lending with its customers through communication inoder to avoid a situation where by the lender have information that the borrower do not have or vice versa about the aspect of product or service quality (adverse selection). According to Boot (1994) through communication banks will be able to know every information about their customer which will enable them to know the safety, the purpose of the loans given to customers and the customers will also know about the services offered by the bank and by doing so creating stronger relationship with their customers. According to (Stein 2002), small banks rely on relationship lending to produce more soft information on their customers than large banks. In the same line, small firms that do not have audited financial statements or sufficient pledgeable collateral rely on relationship lending. The fact that small banks and firms rely on relationship lending deserves research indeed. This can be particularly well-suited in the context of microfinance organizations as the majority of institution are small and are working with firms that lack pledgeable collateral to access credit markets.
Relationship lending adds value through various channels. Relationship lending facilitates the information exchange between the borrower and the lender. Lenders invest in generating information from their client firms and borrowers are more inclined to disclose information because of the preservation of certain confidentiality (Yosha, 1995). The lower informational asymmetric make it possible to overcome problems of moral hazard and adverse selection otherwise inherent in credit markets. For instance, they ameliorate the project choice moral hazard (Diamond 1991) and solve agency problems of managerial behavior (Weinstein and Yafer 1998). Relationship lending allows for loan contracts that are welfare enhancing which otherwise could not be contractible.
Networking; is a socio-economic business activity by which business people and entrepreneurs meet to form business relationship and to recognize, create or act upon business opportunities, share information and seek potential partners for ventures (Maria 2016). Through networking banks and customers will be able to meet or connect in order to share information about the services offered by the banks, the quality of the services offered and how can they improve this services. By doing so the banks will be able build relationship with their customers because the banks will be able to know what their customers expect from them and what type of customers they are dealing with.
Provision of multiple products; Banks provides more services to a customer, it creates a stronger relationship with the customer and gains more private information about him or her. By providing different services the relationships that are encountered can potentially benefit both the banks and customers (Boot 1994). By offering more service to customers, lenders may develop information about a borrower in the process of lending and building a relationship with the firm. If this information is private, then lenders will not be compelled by market completion to pass their lower cost along to the borrower. Lenders may instead choose to lend additional capital to firms which they now view as safer and thus more profitable and also Commercial banks including private and nationalized banks are providing varied services to attract the customers’ community since it is treated as asset of bank to use in order to make profits (Moya 2009). Moya (2009) points out that for retail bankers to meet the changing preferences of the customers and to stay ahead of competitors its their responsibility to provide quality and efficient services.
As a bank provides more services to a customer, it creates a stronger relationship with the customer and gains more private information about him or her. Such relationships can potentially benefit both the banks and their customers. For instance relationship banking can help banks in monitoring the default risk of borrowers, providing the banks with a comparative advantage in lending. Relationship banking can also lower banks cost of information gathering over multiple products. Depending on the competitiveness of the banking sector, such benefits to banks can lead to increased credit supply to customers, through either greater quantities and or lower prices of credit (Boot and Thakor,1994).
The theory of financial intermediation suggests that relationship lending has a bright side and a dark side (Boot 2000). Strong bank-borrower relationships help reduces asymmetric information between lenders and borrowers. But at the same time these relationships can create hold-up problems whereby the lender captures the borrower to extract rents. Hence, the overall effect of strong bank relationships is a trade-off in costs and benefits between lenders and borrowers through interactions across time, space, and financial products. Bank relationship produces an asymmetric evolution of the information between the relationship bank, who acquires private information on borrower, and the rest of financial intermediaries outside the relationship (Moya 2009).
The theoretical foundations of relationship banking are found in the modern literature of financial intermediation that acknowledges the special role of banks in alleviating the informational asymmetries in the credits markets. Theoretical contributions offer opposite results on the relation between banking market competition and the incentives of lenders and borrowers to engage in relationship lending. Also Marwa (2008) shows that the first set of theories argues that competition and relationship lending are incompatible. The reasoning is that with competition, borrowers might be tempted to switch to other banks or to the financial market. When banks anticipate shorter relationships, they may respond by reducing their relationship-specific investments and thus diminish the value of relationships.
The ways of good lending practices are safety of the loan, purpose of the loan as the purpose should be productive so that the money does not only remain safe but also provides a definite source of repayment Agier (2009) , also whether the advance provided is profitable as banks must make profits. And also the security of the loan as it has been a practice of banks not to lend as far as possible except against security as security is considered as insurance or a cushion to fall back upon in case of emergency (Thakor 1994)
How relationship lending and bank’s profitability link
Relationship lending helps increase bank’s profitability or it affects bank profits positively as lending relationships have been recognized by economist as an important mechanism for reducing credit rationing (Bolton and Scharfstein, 1996).Credit rationing is a situation where lenders limit the supply of additional credit to borrowers who demands funds, even if the latter are willing to pay higher interest rates. As banks stop considering credit rationing they avoid market imperfection, or market failure as the mechanism fails to bring about equilibrium in the market. Profitability is ability of a company to use its resources to generate revenues in excess of its expenses. In other words, this is a company’s capability of generating profits from its operations.
Profitability of financial institutions specifically banks are affected by internal and external factors .Andreas and Gabrieelle (2009) stated that bank profitability is usually measured by the return on average assets and is expressed as a function of internal and external determinants. The internal determinants include bank-specific variables. The external variables reflect environmental variables that are expected to affect the profitability of banks. Internal factors such as capital adequacy ratio, asset size, net-worth, liquidity ,earnings quality ,risk management quality, people and operating environment are major determinant that are used to analyze the determinants of bank profitability. An external macroeconomic and industry-specific factor includes Effective tax rate, Real GDP growth, inflation, regulation and bank concentration.
Boot (2000) argues that relationship lending allows for implicit long-term contracts, more flexibility in renegotiable hence lowering the cost of providing loan credits and some discretion in order to make use of soft information disclosed during the relationship. When a firm experiences temporary negative shock which prevents it meeting the contracted loan payments, negotiability of contracts ex post can help accommodate the firm with delayed payment or new lending (Boot,Greenbaun and Thakor 1993, Von Thadden 1995) managing bad debts. Relationship lending permits the funding of loans relationships increase credit availability, in particular to the youngest and informationally opaque borrowers, which may have projects that generate few rents in the first period but may be profitable from a long term perspective (Petersen and Rajan 1995). Even more, relationship permit smoothing the loan interest rate over a duration of the relationship (Petersen and Rajan 1995) and over the interest cycle (Berlin and Mester 1998), same way as (Ferri and Messori,2000).
EMPIRICAL LITERATURE RIVIEW
Marwa (2008) found that the modern literature on financial intermediation has primarily focused on the role of banks as relationship lenders. In this capacity, banks develop close relationship with borrowers over time.Such proximity between the bank and the borrower has been shown to facilitate monitoring and screening and can overcome problems of asymmetric information( Boot ,2000).Also according to other schoolars,(Diamond 1998 )and (Thakor,1993) finds out that relationship banking is most directly aimed at resolving problems of asymmetric information. It allows for several special contractual features, including flexibility and discretion, the extensive use of contracts, and the inclusion of collateral requirements which may facilitate implicit long-term contracts and resolve agency and information problems (Boot, 2000).
Boot (2000) and Carey (1998) have shown that relationship lending is not unique of banks. It is important also in non-bank financial institution as finance companies, venture capitalists and debt markets. All this financial institution provide a full menu of financing options for borrowers (letters of credit ,deposits check clearing and management services) with varying degrees of relationships that allow them to acquire proprietary information on their clients and reduce risk through multiple interactions, which are the basis for relationship lending.
The empirical literature on relationship lending does not clearly states the value added of relationship banking.Although,banks acquire confidential (or proprietary) information through multiple interactions with their customers, little is known about how banks obtain these information, what type of information is, and the use they give to this information( Chiesa (1995). In literature, various benefits emanating from relationship banking have been documented. First, different from transaction-oriented banking, relationship lending can facilitate a Pareto-improving exchange of information between the bank and the borrower. It is because the borrower might reveal proprietary information to its bank that it would never have to tell it to the financial markets (Bhattachrya and Chiesa, 1995).
Berger (1999) finds that three conditions are met when relationship banking is present: The lender collects information outside freely accessible public information, the collection of information takes place by means of repeated interactions with the borrower generally through the provision of various financial services and the information remains proprietary or confidential to the lender.
According to Uchida (2006) relationship banking can improve welfare by several channels: Itcan facilitates implicit long term contracting and leaves scope for flexibility and discretion of subtle information; allows for better control of potential conflicts of interest by conveying extensive contracts; relationship may involves collateral that needs to be monitored and that makes the proximity of a relationship essential and it permits funding loans that are not profitable for the bank in the short-term but that make possible value-enhancing inter-temporal transfers in loan pricing.
Marwa (2008) finds out that the effects of relationship lending on bank profitability has the results that offer new insights on the channels that lead to repeated interaction between a firm and a bank. In contrast to work that focuses on the role of relationship in alleviating information and incentive problems in lending, Marwa (2008) finds that the source of value in relationship lending is not limited to enhanced monitoring. Relationships enable banks to sell borrowers a variety of other profitable financial services, as well as gain access to additional borrowers to whom they can sell these services.
According to Marwa (2008) relationship lending will continue to be important into the future as banks compete for the same market. Banks continue to use price wars and services to takeover corporate customers from the competition. This as shown in the findings has an impact in the assets as well as income from the lost deals and ultimately the overall bank profitability.
CHAPTER 3; RESEARCH METHODOLOGY
In this chapter the following aspects of research methodology are discussed; the research design used to conduct the study, research approach, target population, sampling techniques, sample size, data collection methods that were used, and presentation of data in order to generate the findings of the research.
The study adopted the causal studies as it examines whether one variable causes or determine the value of another variable. According to Mugenda (2003) causal studies observe variation in the variable assumed to cause change in the other variable, and then measure the changes in the other variable. In this case the researcher will be able to examine how relationship lending (independent variable) influences or affect bank’s profitability (dependent variable).
3.2 RESEARCH APPROACH
The research approach method used in this study is quantitative, as involves gathering information in numeric form and data is gathered using more structured research instrument.
3.3 TARGET POPULATION
According to Mugenda (2003) population refers to an entire group of individuals, events or objects having common observable characteristic. The target population for this study is all commercial banks in Botswana.
A non-probability sampling will be used in this study as it is convenient. It will allow the researcher to select or interview people in the same units and those units are easily reached by the researcher as they are in the same place. In this study the researcher is located in Gaborone so she will be using banks in this area to carry out her studies.
3.4.1 SAMPLE SIZE
The researcher uses one commercial bank as sample size.
3.5DATA COLLECTION METHOD OR RESEARCH INSTRUMENT
In this study questionnaires will be used to set questions that can generate the information necessary to accomplish a research project’s objectives.
3.6DATA COLLECTION PROCEDURES
In this study methods of data collection involved both primary and secondary data. The primary data was derived from questionnaires that were issued and secondary data was collected from bank’s financial statements and also from journals, or used the information that already exists.
3.7 DATA ANALYSIS AND PREPARATIONS
The data collected was analyzed using charts, tables and linear regression analysis.
3.8 ETHICAL CONSIDERATION
This is moral principles that influence the activity of research at all levels and it respect confidentiality and privacy.
3.9 VALIDITY AND RELIABILITY
According to Borg and Call (1998) validity indicates whether the items measure what they are designed to measure. So in this study consultations and discussions was done with the supervisor to establish content validity. Also reliability like validity is a way of assessing the quality of the measurement procedure to collect data in a research, so in order for the result in the study to be considered valid the measurement procedure must first be reliable. In this study the researcher used the same instrument more than one time in order to obtain same answers.
3.10 CHAPTER SUMMARY
The chapter will describe the methods that would be used to provide answers to research questions in the study. The aspects of research methodology will be discussed like research design, approaches and data collection methods in order to provide answers to research questions.