Practical Aspects of Relationship Lending: A Lenders Perspective by Felipe O.

Calderon 1

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The paper focuses on the nature of interactions between small and medium-sized entrepreneurs (SMEs) and loan officers that define the quality of lending relationships. We examine interactions at the transaction level from the perspective of loan officers using ethnographic techniques. The paper provides insights into close-up behaviour of SMEs, which influences the nature of their relationship with loan officers. The paper includes a discussion on the realities and challenges of relationship lending and offers practical advice to educators and entrepreneurs. The evidence suggests that loan officers support SMEs who regularly provide financial information and demonstrate professional behaviour.

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Introduction This paper is about my experience as a practitioner/researcher participating and observing how loan officers interact with bank borrowers specifically small and medium-sized entrepreneurs (SMEs). The purpose of this paper is to investigate the nature of interactions between loan officers and SMEs. The paper seeks to answer the questions: how do loan officers and SME borrowers interact, and how do the resulting relationships affect access to additional financing and concessions. Relationship lending is a key ingredient in the viability of SMEs

Felipe O. Calderon is Regional Director, Underwriting at the Business Development Bank of Canada. He is also concurrently a Ph.D. student in International Business at the University of St. Gallen. His research interests include relationship lending, turnaround management and immigrant entrepreneurship. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author. Address correspondence to: Felipe O. Calderon, BDC Tower, Suite 2100, 505 Burrard Street, P.O. Box 6, One Bentall Centre, Vancouver, British Columbia, V7X 1M6. Tel: (604) 666-7869; Email: felipe.calderon@bdc.ca.

because it reduces informational opaqueness. This paper aims to improve our understanding of the role of interactions in relationship lending.

Banks are a major source of financing for SMEs. Unlike large corporations, access to bank financing can make or break the viability of SMEs. The first round of financing has always

been challenging for SMEs, who are informationally opaque. Once financing is in place, banks play a critical role in providing additional financing and concessions particularly in times of financial distress. Examples of concessions are postponement and reduction of loan payments. Access to additional financing and concessions is influenced by the nature of interactions between loan officers and SMEs. This study includes a discussion of the transactions that form the foundation of multiple interactions between loan officer and SME from loan origination to maturity. Ethnographic techniques were employed to study interactions at the transaction level from the perspective of loan officers who are the front-line representatives of banks. The evidence suggests that loan officers support SMEs who regularly provide financial information and updates on plans and projects, and display professionalism in terms of returning telephone calls and emails, and showing up for meetings.

The paper unfolds in the following manner. First, existing literature is reviewed. Second, the research methodology is explained. Third, discussion on the nature of interactions is provided. Fourth, I will look into the realities and challenges of relationship lending. I will conclude with practical implications for educators and entrepreneurs and suggestions for further research.

Review of Prior Studies The purpose in this section is not to conduct a comprehensive study of the literature on relationship lending but to bring out the gap. Udell (2008) offers the following description of relationship lending as defined by finance scholars:

Relationship lending is a type of loan underwriting that primarily depends on proprietary soft information about the borrower. Soft information is qualitative information

acquired by the bank over time through multiple interactions with the borrower, often through the provision of multiple financial services (Boot, 2000). Soft information

includes assessments of an SMEs future prospects, compiled from past interactions with its suppliers, customers, competitors, and other businesses and business associations in the local market.

According to Elyasiani and Goldberg (2004), it was Lummer and McConnell (1989) who identified that relationship lending is not built when banks enter into a new credit agreement but is acquired over time through multiple interactions with the borrower. The information

generation over time plays a key role on whether additional financing will be provided in the future. However, existing literature is largely focused on empirical studies investigating the impact of relationship lending on collateral, interest rate, and loan workouts. Elsas (2005) and Garriga (2006) find that relationship between a bank and borrower is difficult to observe, hence it is an empirical task. As a result, a variety of proxies have been used in empirical studies to draw conclusions on the impact of relationship lending on loan terms and conditions. Duration of a bank-borrower relationship is one of most commonly used proxies in empirical work

followed by the number of bank relationships and share of the borrowers total debt. Ono and Uesgusi (2009) report that results of empirical studies have been mixed. Some studies observe that there exists a negative relationship between duration of bank-borrower relationship and collateral requirement while others obtain a positive relationship. Nam (2004) reached the same conclusion that empirical evidence on the merits and demerits of relationship lending is often mixed.

There are limited studies on the nature of interactions that define the relationship between the loan officer and the entrepreneur. One of the studies was prepared by Lehman and Neuberger (2001) based on a survey of German banks. They conducted a quantitative study which revealed that social interactions between the loan officer and bank manager have a positive influence on the availability and terms and conditions of loans. The data set was based on a survey completed by 1,200 bank loan managers in Germany in 1997. The survey included, among others,

questions relating to the nature of the relationship between the loan manager and the SME such as nature of experience, willingness to provide information, and stability of the relationship.

Two studies identified the critical role of loan officers in the collection of soft information, which is the foundation of relationship lending. First, Scott (2006) investigated how turnover of loan officers affected the availability of credit to the entrepreneur. The relationship was

empirically confirmed using data from the 1995 and 2001 Credit, Banks, and Small Business Surveys conducted by the U.S. National Federation of Independent Business. recognized the critical role of loan officers in the generation of soft information. The study Second,

Uchida, Udell, and Yamori (2006) sought to test whether close relationships between the loan officer and entrepreneur led to accumulation of soft information and whether the accumulated
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information was beneficial to opaque SMEs in the Japanese market. The data set of the quantitative analysis utilized the results of the Management Survey of Corporate Finance Issues of SMEs in the Kansai area. The study had mixed results and concluded that more research is needed in this area.

The literature on relationship lending has grown over the past decade. However, research has focused on the use of quantitative techniques based on survey-based data. Davidsson (2008)

argues that questionnaires do not capture attitudes, personal traits, intentions, or real-world behaviours. The interaction dimensions of relationship lending are too dynamic and complex to be captured in survey-based research.

None of the existing research has studied the nature of the interactions that define the relationship between loan officer and entrepreneur. This paper contributes to the study of relationship lending by providing qualitative insights into the multiple interactions between loan officer and SMEs.

Research Methodology The study is different because it does not use quantitative techniques based on survey-based data. I argue the importance of the methodological choice of studying relationship lending at the level of interactions. Ethnographic techniques were employed to study interactions at the

transaction level from the perspective of loan officers who are the front-line representatives of banks. The ethnographic approach is ideal since the interaction dimensions of relationship lending are too dynamic and complex to be captured in survey-based research. The advantage

of ethnography is that the researcher is able to observe and hear what the entrepreneur would not openly discuss during structured interviews (Moeran, 2005).

It is important to recognize that qualitative ethnographic approach has its limitations relating to the objectivity of the researcher/participant and the restricted area of research (Neyland, 2008). However, the objective of this study is to provide practical insights and examples of reallife situations rather than measuring a phenomenon that involves soft issues where quantitative techniques may not be appropriate (Jack and Anderson, 2002). The insights and examples have been drawn from my 20 years commercial lending experience which spans from the Philippines, Hong Kong, and finally Western Canada involving SMEs in various stages of development including businesses in financial distress and turnaround situation.

In this paper, Canadian definition of an SME is being used which is an owner of a business that employs no more than 500 employees and generates sales of no more than $50 million Canadian dollars. The study is limited to loan officers who specialize in commercial loans. Commercial or business loans assist companies to finance the start-up of ventures, purchase of buildings, equipment, inventory, and to provide working capital.

Focus on Interactions Transactions that transpire between a loan officer and SME after loan origination is underresearched in existing literature. Many researchers have alluded to the multiple transactions that shaped the lending relationship between loan officer and SME but no study has provided a detailed description. In addition, prior studies have focused on favourable terms and conditions

on additional credit as the primary benefit of relationship lending to the entrepreneur. Approval of the first loan is only the beginning of the relationship between the loan officer and SME. Many activities occur between loan origination and maturity that will have an impact on the quality of the lending relationship. What are these transactions that inevitably result in

interaction between loan officer and SME? The following discussion will show that these transactions are not only administrative in nature but also include concessions, which are most needed during periods of financial stress.

Initiated by the Loan Officer Periodic review: Loan officers are required to conduct a regular review of their accounts. Depending on the risk profile of the account, the review may be on an annual, semi-annual, or quarterly basis. The review involves an analysis of financial information and meeting with the SME borrower and an inspection of the charged assets, if applicable.

Business development: Loan officers call on their existing clients to source new loans.

Loan

officers have objectives to generate a minimum amount and number of loans per year. Therefore, loan officers regularly contact their clients to explore opportunities for new loans. For instance, if the borrower mentioned that there is a plan to purchase additional equipment after six months, then the loan officer will diarize to contact the client in the future. Loan officers also look at their existing clients as potential source of referrals for new loans. An existing client could introduce their loan officer to suppliers and customers.

Initiated by the SME Reduction or postponement in payments: The SME borrower approaches the loan officer to reduce or postpone principal payments for a few months to assist cash flow. There are several possible reasons for this request. Common reason is the general slowdown in business due to the downturn in the economy. On the other hand, a request for reduction or postponement in loan payments is not necessarily a cause for concern. The company may have won a big contract which requires extra working capital to deliver the product or service.

Changes in personal and corporate arrangement: During the life of the loan, changes in the structure of the company may require consent from the bank. Changes in the ownership

structure may require the bank to consent to release or add a personal or corporate guarantor.

Amendments to charged assets: The company may sell assets such as a parcel of land or equipment, which requires the Bank to release its charge on the asset. This may entail

negotiation between loan officer and SME borrower on whether or not the banks loan will be partially paid down or not.

Realities of Relationship Lending What really happens from the time an SMEs loan application is approved to full repayment? Following is a discussion of realities and behaviours that have been observed that either enhance or diminish the relationship between loan officer and borrower.

Relationship Busters Loan agreements always include a condition for the borrower to submit year-end financial statements. In Canada, there are three types of the financial statements: Notice to Reader; Review Engagement; and Audited. The difference among the three types is the degree of assurance being provided by the professional accountant that the financial statements were prepared in accordance with generally accepted accounting principles. The degree of assurance for Notice to Reader is low, followed by medium for Review Engagement, and high for Audited financial statements. statements. SMEs are usually required to submit Review Engagement financial

A common cause for concern is that some SMEs submit Notice to Reader year-end

statements because they are cheaper to prepare. Following are some comments received by loan officers from SME-borrowers:

Why do I have to submit Review Engagement financial statements, which are more expensive, when all my loan payments are up-to-date?

I challenge the bank to call my loan because I only submitted Notice to Reader financial statements instead of Review Engagement.

With the above comments, it would be difficult for the loan officer to seek exception to accept the Notice to Reader financial statements when the borrower applies for additional financing or requests for a concession such as postponement of payments. It also becomes a challenge for the loan officer to complete the periodic review when the financial information does not comply with what was stipulated in the loan agreement. Periodic reviews are being

completed to categorize properly the customers risk profile, which dictates the Banks provision for loan losses.

As mentioned earlier, loan officers seek out to meet with existing clients as part of their periodic review and marketing activities to source new loans. Following are some comments received from loan officers:

After several unreturned telephone messages, I was finally able to connect with the client and set up an appointment to discuss how things are going with the business. I was at the clients office at the appointed time but the customer did not show up. No reason was provided for the absence.

The client was outright suspicious of my request for a meeting. The client felt that it was an intrusion in the private affairs of the business.

At this point, it is important to highlight why loan officers are eager to develop a relationship with their clients. Loan officers compensation and career advancement are directly related to their capacity to book loans which generate fee and interest income for the bank. Experienced loan officers recognize that clients, at some point in their business cycle, will request for a concession to overcome temporary challenges. It is critical for the loan officer to be able to obtain approval for these concessions in order to develop customer loyalty which will hopefully result in additional loans or an introduction from the SME to suppliers and customers.

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Relationship Boosters It is equally important to present examples of entrepreneur behaviour that support the development of a positive relationship with the loan officer. Following are best practices of SMEs that have been repeatedly observed by loan officers:

Many SMEs have considered their loan officer as part of the business family. SMEs proactively invite their loan officer to visit the company premises to give an update on the progress of the business including challenges.

Loan officers appreciate SMEs who take the time to understand what the bank is looking for in its financial statements to ensure successful application for subsequent financing. Some SMEs, who are not adept with financial information, bring along their controller and sometimes the external accountant, to ensure a common understanding of what is required by the bank.

Loan officers look for a professional relationship and not a social relationship. Loan officers are not comfortable being invited to family dinners or accepting gifts. What

they are looking for is prompt submission of financial information and the SMEs openness to regular business meetings.

In a survey commissioned by the Canadian Bankers Associations (2009) on SMEs and bank relationships, it was identified that 92 percent of the SMEs revealed that having a face-to-face relationship with their lender as the most important factor in their relations with their banks.

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This provides collaborative evidence that personal contact between loan officer and SME is a prerequisite to a successful lending relationship.

Challenges of Relationship Lending Based on the foregoing discussions, it appears that there should be a natural tendency from loan officers and SMEs to create a harmonious lending relationship. From the point of view of loan officers, a close relationship with the SMEs translate to more loans in the future which means higher compensation and career advancement. From the SMEs perspective, a positive relationship with the loan officer means the possibility of more financing and concessions in the future. Based on this premise, the information asymmetry of SMEs should no longer exist, however this is not the case in the real world. What are then the challenges that prevent relationship lending from happening?

Turnover of Loan Officer Frequent turnover of loan officers is a reality in the banking industry. SMEs have expressed their frustration over dealing with too many loan officers during the life of the loan. The

reasons for the turnover in loan officer are either internal or external. Internal turnover is usually a result of the loan officer either being promoted to a senior position or being transferred to a different job within the bank. External turnover is due to either voluntary or involuntary

departure of the employee. Many business graduates apply for a loan officer position only to find out that it is not the dream job they have expected it to be. SMEs should learn to accept that loan officer turnover is one of the challenging realities of relationship lending. It is

recommended that SMEs should develop a strategy in dealing with loan officer turnover as if it is

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part of their daily business activities. following:

Best practices that have been observed include the

Invite the new loan officer to the business premises and provide a tour of the facilities. Maintain copies of documents and whenever possible, confirm discussions by email to ensure a paper trail through which the new loan officer can pick up any negotiations.

Maintain contact with both the loan officer and the next level supervisor to ensure continuity of relationship if one of the two bank employees should move on.

The old adage if you cant beat them, join them is truly applicable to SMEs when it comes to loan officer turnover. Some SMEs continue to complain about this phenomenon while others have moved on to embrace this reality and have formulated strategies to deal with it.

Asset versus Liability SMEs continue to identify the loan officer with the debt recorded as a liability in the balance sheet. There is a need to educate SMEs that their loan officer should be considered as an asset that could be mobilized to achieve business objectives. The recent financial crisis highlighted the importance of the loan officer as an additional resource to SMEs. Loan officers may not possess hands-on entrepreneurial experience but they have witnessed both good and bad business practices. The more experienced loan officers have seen their clients successfully or

unsuccessfully weather obstacles through bust and boom economic cycles. In addition, the loan officers belief in the company can sometimes make the difference between approval and decline of a loan application or financial concession. It has been observed that some loan officers would put their reputation on the line to support an SMEs application. Bank authorizing officers can
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sometimes be convinced by the loan officers passion towards the SMEs business. At the end, a banking relationship is both an asset and liability and it is up to educators and business advisors to convince SMEs that a strong lending relationship is the key to mitigate information opacity.

Friend or Foe There is a perception among SMEs that loan officers are like bureaucrats who enjoy a stable job and regular pay. There is a misconception that being a loan officer is a 9 to 5 job from behind an office desk. Being a loan officer is almost entrepreneurial. Commercial loan officers act as salespeople, which involve frequent travel to persuade firms to obtain financing from their institution. Loan officers also maintain relationships with other professionals who may refer

potential loan applicants. These professional include commercial realtors, equipment suppliers, accountants, and lawyers. Loan officers belong to chambers of commerce and other business

associations to increase their presence in the local community. Their day could start with an early business breakfast meeting and end with a dinner function. Some loan officers have been known to meet clients after office hours and even on weekends. Loan officers, like

entrepreneurs, face the uncertainty of when the next sale or loan will occur. Every time loan officers recommend a loan, they put their reputation and career on the line hoping that the financing will not turn into a bad loan. Sometimes, SMEs get very frustrated and agitated

during loan origination when they feel too many questions and documents are being asked by the loan officer. It has happened so many times that the relationship has been damaged even before it got started. It is important for SMEs to recognize that loan officers speak on their behalf to the bank executive who authorizes the loan. When loans are declined, loan officers are equally

penalized because they too have invested the time and effort which could have been spent with another loan applicant.
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Implications for Practice and Research The practical value of this paper is to increase the awareness among entrepreneurs, researchers, educators, and business advisers that interactions with loan officers are critical to the viability of small and medium-sized businesses. There appears to be too much emphasis on the preparation of business plans but lacking in coaching entrepreneurs on how to manage relationships. There is a proliferation of academic research that provides evidence that a strong lending relationship is beneficial to SMEs because it reduces information asymmetry. Therefore, educators should train future SMEs to develop a strategy on how to reduce information opacity to ensure favourable terms and conditions on loans and subsequent financing, and approval of requests for concessions. I have barely scratched the surface of financial concessions which is a topic that is under-researched. Further studies in relationship lending should consider looking into financial concessions as equally important as obtaining additional financing.

SMEs should learn to recognize that a relationship with their loan officer is part of their social capital and business network. Researchers have suggested that social capital and interfirm alliances are a source of competitive advantages (Stuart and Sorenson 2007; Schreiner, Prashant and Corsten, 2009). There is an inherent focus among SMES on elaborate marketing plans supported by complex financial forecasts. There is a need to expand the focus on how to build effective networks with their financing sources and utilize loan officers as part of a resource for advice and best practices.

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There is no universal definition of SME. There is a need to break down the definition in terms of micro, small, and medium business in order for research to be more relevant. It is apparent that a business owner with only 10 employees has a different approach to relationship with the loan officer than a business owner with 100 employees. In the latter, it is possible that the chief financial officer or Controller is the primary contact of the loan officer. What are the implications to relationship lending when the business owner delegates responsibility of interacting with the loan officer to an employee?

Finally, this paper could be extended by investigating how immigrant entrepreneurs differ in their interactions with their loan officer compared to local business owners. Further studies could also contribute to broadening our understanding of the globalizations of SMEs. When SMEs open expand overseas, it is possible that financing will be required from banks in the host country. It would be interesting to study the interaction between SMEs from a foreign country and loan officers of the host country

References
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Uchida, Hirofumi, G. F. Udell, and N. Yamori (2006). Loan Officers and Relationship Lending, Regional Finance Workshop of the Research Institute of Economy, Trade, and Industry (REITI) Discussion Paper Series 06-E-031, Wakayama, Japan. Udell, Gregory F. (2008). Whats in a relationship? The Case of Commercial Lending, Business Horizons, 51 (2), 93-103
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