During the last decade, regulatory changes and technological innovations have allowed banks to increase their geographical reach. While these changes make banks able to better diversify their loan portfolio, they can also affect lending relationships since especially for opaque borrowers banks collect information through a face-to-face interaction (Petersen and Rajan, 2002).
Since Diamond’s (1984) seminal paper, it has been argued that financial intermediaries arise in order to overcome the consequences of informational asymmetries between lenders and borrowers. However, banks differ in their ability to deal with opaque borrowers.
Stein (2002) argues that within large banks, information has to go through several hierarchical layers (organizational complexity) after which it could be difficult to transfer, especially when information is not verifiable (soft information). As a consequence, large banks loan officers may have less incentives to acquire soft information since they know ex-ante that it is useless in the competition among branches for internal financial resources (internal capital markets). On the empirical grounds, Berger et al. (2005) support this result by verifying that small banks have a comparative advantage in granting loans to small firms, whose credit risk assessment requires a greater usage of soft information with respect to large businesses.
In this paper, we develop a very simple model showing that the ability of banks to deal with opaque borrowers depends not only on banks organizational complexity, which is Stein’s argument, but also on the distance between banks’ headquarters and borrowers too (from now on, functional distance). To this aim, we extend Stein’s argument in different directions. First, we argue that there is a continuum of information verifiability that ranges between the boundaries of soft (totally unverifiable) and hard (totally verifiable) information. Second, banks may, at least partially, harden soft information. Third, the ability of banks to harden information may depend on the distance of banks’ headquarters from borrowers In particular, we argue that the distance of banks’ headquarters from borrowers makes communication codes difficult to develop within banks.
The basic intuition is that soft information becomes increasingly difficult to transfer through banks’ organization from those who are in charge of gathering information the loan officers of the lending branch to those who delegate information acquisition the lending bank headquarters as functional distance increases. This also implies that, since financial resources are allocated within branches by the headquarters, ‘distant’ loan officers run a higher risk of being rationed by their headquarters than loan officers that are ‘close’ to their headquarters. By assuming that loan officers’ pay-off is an increasing function of the amount of lending granted by their branch, the loan officers’ incentives to gather soft information decrease as functional distance increases.
There are many reasons for arguing that functional distance may affect the information transmission mechanism within a bank. First, banks’ headquarters may be less able to interpret the information they receive from distant loan officers than from close ones. Indeed, banks’ headquarters are less informed than loan officers since it may be too expensive for distant headquarters to collect information requiring a direct interaction with the market.
Second, cultural differences, which may be relevant not only in the case of foreign banks entering in the domestic market (Berger et al., 2001) but even within a country, may render the transmission of information difficult. Third, communication problems may stem from differences between headquarters and loan officers in terms of their past experience.
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