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Figure 3 presents the share of collateralized loans for the six rating categories. At first it is ... The collateralized part of the total loan of borrowers without personal.
Guarantees, Borrower Quality, and Relationship Lending: a Note on the German Mittelstand

Dirk Schiereck*

Abstract

Some researchers believe that there is only little difference between business and personal risks among small businesses. Personal assets and wealth can become subject to business risks depending on the organizational and legal structure chosen for the business. By the choice of the organizational and legal form the owner has a chance to increase the separation between the risks mentioned above. However, lender’s requirements for personal commitments, e.g. guarantees, mitigate the benefits of limited liability provisions. To our knowledge, Ang/Lin/Tyler (1995) and Avery/Bostic/Samolyk (1998) are the only empirical studies about the use of these personal commitments. While these papers concentrate on the lending relationships of small business borrowers we provide additional evidence for German medium-sized companies, the so-called German Mittelstand. The study is based on credit files of five leading German banks, thus relying on information actually used in the process of bank credit-making and contract design. In particular, bank internal borrower ratings are used as indicators to evaluate borrower quality, and the bank’s own assessment of its housebank status serves to identify information-intensive lending relationships.

Our results suggest two points: First, internal collateral appears to be complement for outside personal commitments. Poorly performing companies have to provide more inside collateral and pledge guarantees with a higher probability than good borrowers do. Secondly, mediumsized corporation in Germany are less likely to provide guarantees than unincorporated firms. Therefore, we can conclude that the owners of medium-sized companies have the market power to separate between business and personal risks.

JEL Classification: G21

* Endowed Chair for Banking and Finance, European Business School, International University Schloss Reichartshausen, D-65375 Oestrich-Winkel, Germany. Tel.: ++49/6723991 214, Fax: ++49/6723-991 216, e-mail: [email protected]

1.

Introduction

Guarantees that make owners personally liable for business debt are a common feature of small and medium credit arrangements. To the extent that they mitigate the loss exposure of lenders. Firm owners, who are able to make personal commitments, can probably negotiate better credit terms. Sole proprietorships and partnerships have unlimited business and personal liability which gives lenders an implicit claim on all business assets and personal wealth of the owners even in the absence of personal commitments. Under non-corporate organizational forms, the pledging of guarantees increases the implicit claim on all assets with an explicit claim on personal wealth including future income. This may imply that many firms cannot be viewed as financial entities that are entirely separate from their owners. By the choice of organizational form, the owner has a mechanism to increase the degree of separation. Despite their potential to affect which firms receive loans, very little is known about how personal commitments are related to financial arrangements in practice. The related literature on the role of guarantees is limited, because only a few data sets include sufficient information to permit a thorough study. There are two studies by Ang/Lin/Tyler (1995) and Avery/Bostic/Samolyk (1998) using data from the National Survey of Small Business Finance (NSSBF) to provide empirical evidence for the use of personal guarantees in the small business sector of the US. Both studies document the high degree of non-separation of business and personal risks. Our study is based on credit files of five leading German banks, thus relying on information actually used in the process of bank credit-making and contract design. In particular, bank internal borrower ratings are used as indicators to evaluate borrower quality, and the bank’s own assessment of its housebank status serves to identify information-intensive lending relationships.

Our results suggest two points. First, inside collateral appear to be complements for outside personal commitments. Poorly performing companies have to provide more inside collateral and pledge guarantees with a higher probability than good borrowers do. Second, mediumsized corporations in Germany are less likely to provide guarantees than unincorporated firms. Therefore, we can conclude that the owners of medium-sized companies have the market power to separate between business and personal risks. The result of this analysis is organised in the following manner. Section 2 contains a description of the data set and a number of descriptive statistics. Section 3 is comprised of regression results and a discussion of the findings. Finally, Section 4 concludes with some remarks on implications of the results and suggestions for future research.

2.

Data Set and Descriptive Statistics

2.1

Data Description

Our data on bank-borrower relationships was drawn as a random sample from a set of credit files provided by five leading universal banks in Germany: Bayerische Vereinsbank, Deutsche Bank, DG Bank, Dresdner Bank and WestLB. These banks represent five of the nine biggest banks in Germany at the end of the year 1996. The data covers the period from January 1992 to December 1996. For each bank-borrower relationship the information set contains general firm characteristics (legal organizational form, branch etc.), the specific terms of the loan contracts (interest rate premium, maturity, volume, collateral, lines of credit etc.), balance sheet data and the banks’ internal borrower ratings.1

1

See Elsas et al. (1998) for a detailed description of the data set. Other studies using the same data base are among others Elsas/Krahnen (1998), Ewert/Schenk/Szczesny (2000) and Machauer/Weber (1998).

Since the focus of this analysis are medium-sized corporate debtors, the set of feasible relationships is limited to firms with an annual turnover between DM 50m and 500m. Firms with registered offices in the eastern part of Germany, the former German Democratic Republic, were excluded. The nature of such relationships might be dominated by industrial restructuring with a specific risk structure that is expected to differ from that of debtors in the western part of Germany. A minimum loan size of DM 3m was imposed to ensure a minimum level of information on a given borrower’s indebtedness to competing banks. Borrowers fulfilling this requirement are subject to the regulatory notification requirement of the German Banking Act (Kreditwesengesetz). Article 14 of the Kreditwesengesetz requires each bank to report the name and loan terms of each debtor with a consolidated debit balance of at least DM 3m. On behalf of the Federal Banking Supervisory Authority (Bundesaufsichtsamt für das Kreditwesen), the German Bundesbank collects all notifications and summarizes them in consolidated statements per borrower. These statements are accessible by all reporting banks. Finally, only firms were considered which had at least one long-term loan with a fixed interest and repayment schedule. The sample contains 200 bank-borrower relationships, 40 from each bank. It is divided into two subsamples. Subsample N consists of 125 individual borrowers, 25 from each bank, which was taken randomly from the population of all credit relationships fulfilling the above described requirements. Usually, the data set includes the whole bank-borrower history with the complete set of information variables for the period 1992-1996. The second subsample P was drawn from a subset of borrower population with the specific characteristic that these borrowers were potentially distressed. This subsample consists of 75 credit relationships, 15 from each bank. The term “potentially distressed” is defined by being rated at least once in the category 5 or 6 on a calibrated credit rating scale of 1-6 (described below). Subsample P is used to strengthen the number of observations for the poor rating categories which otherwise would be too small for statistically significant findings.

The calibrated rating scale from 1-6 was created by Elsas et al. (1998) to allow a comparison of the internal rating classifications of the five above mentioned banks. Therefore, the original rating schemes were transformed into the new six rating classes using the banks’ definitions of each rating category. Within the new rating class 1 borrowers are comprised being very good, within class 2 being above average, 3 being average, 4 being below average, 5 being potentially distressed and 6 being very much in danger of default. Subsequently, this classification is also used to indicate borrower quality.

2.2

Descriptive Statistics

Usually the banks in our sample rate their borrowers once a year. Analysing a time period of five years (1992-1996) the data sample should include nearly 1,000 observations. However, the real number of observations is smaller, especially, because missing values for some variables decrease the data set. Altogether, the study is based on 851 observations, 666 ratings for loans without personal commitments and 185 where guarantees were pledged. Classifying the loans with personal commitment by borrowers’ size underlines the homogeneous structure of the sample under consideration. Total assets of 121 observations (65%) range between DM 4m and 5m, less than 10% below DM 4m and about 25% above 5m.

18%

46%

32%

89%

Figure 1:

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