How do banks adjust when faced with a sudden rise in capital requirements? The almost instinctive response is “they reduce lending”. But this is one side of the coin. The flip side says that they also engage in granting collateralized credit rather than uncollateralized. But the increased collateralization affects small borrowers that lack collateral to pledge. However, relationship banking matters. That is what advances a paper recently published by Artashes Karapetyan, Hans Degryse (KU Leuven and CERP) and Studipto Karkamar (Banco de Portugal and UECE). In their research, it becomes clear that borrowers that have long-standing relationships with banks have better access to credit and this could be due to soft information that banks collect over the course of a lending relationship.
The Asymmetric Information Problems
A large literature in economics and finance has long recognized the importance of asymmetric information problems. Lending to small businesses, a core source of economic growth, is especially vulnerable to severe information problems. However, it is important to note that financing small businesses remains a key factor in economic recovery after a crisis. And banks possess several technologies to reduce asymmetric problems that are prominent in credit markets.
Why Introduce Collateralized Loans?
In October 2011, the European Banking Authority (EBA)  conducted a Capital Exercise. It focused on the capital and term funding needs in the EU banking sector against the backdrop of the increasing concerns regarding sovereign debt. It was designed to help banks to continue their lending activities. Banks were therefore required to strengthen their capital positions by building up a temporary capital buffer against sovereign debt exposures to reflect current market prices. In addition, banks were required to establish a buffer such that the Core Tier 1 capital ratio reaches 9%. Furthermore, they were expected to build these buffers by the end of June 2012. It was said that the building of these buffers would allow banks to withstand a range of shocks while still being able to maintain an adequate capital level. The increased capital requirements imposed on some major European banking groups favored collateralized lending.
Why collaterals? On average, collateralized loans have a lower risk weight, i.e. loans secured by collateral require less regulatory capital than unsecured exposures. What this means is that it is cheaper for the bank to extend collateral-based loans relative to screening-based loans, where the bank has to exert effort to know more about the quality of projects being financed.
How To Overcome Asymmetric Information: Choosing between Collateral and Screening
In order to overcome asymmetric information, banks have a choice. They can either choose collateral or screening. On the one hand, screening is costly because of the collection of information about project type involved. On the other, collateral is also costly for both banks and borrowers . Which path to choose and how these choices may affect the real economy?
Here is what they find:
In normal times, borrowers’ access to funding is more likely to be unsecured if the ensuing relationship is likely to be a long-term one;
Borrowers’ collateral requirements go down during the course of the relationship;
Banks may stay away from costly collateral and turn more to unsecured loans (screening) at the start of a bank-firm relationship when the borrower has a high potential relationship length
Banks affected by the EBA requirements are in general 6-10 percent more likely to require collateral than their unaffected counterparts.
So, how is all this important? Let us consider some of the main implications and how this type of bank behavior could affect the real economy. The results obtained have direct implications for the access to finance of small and medium-sized enterprises in times of crisis and such enterprises represent 99 percent of all businesses in the European Union.
Because financing a small business is risky, most creditors choose to require collateral. Yet, the availability of collateral remains a key challenge especially at the initial stage of business life. Therefore, policymakers must ensure that such businesses do not face credit constraints and continue to grow. If banks engage in more collateral-based lending, SMEs are more likely to be affected as these firms do not have sufficient collateral to pledge, unlike large corporates. It becomes important, if not vital, to ensure access to credit because, as is well established, financing small businesses remains a key factor in economic recovery after a crisis.
The European Banking Authority (EBA) supports the agreement at EU level on measures to restore confidence in the banking sector. These measures form part of a broader package aimed at addressing the current situation in the EU by restoring stability and confidence in the markets.
 Collateral is costly due to liquidation losses in case of default, and this cost is proportional to the amount of collateral a given borrower has pledged.