This was the message delivered by Brian Uzzi (IPR-Kellogg) to Federal Reserve chairman Alan Greenspan and some 400 economists, bankers, venture capitalists, and entrepreneurs at a conference March 8-9 in Arlington, VA.
Uzzi was one of 14 speakers at the two-day meeting organized by the Fed to address the problem of "Business Access to Capital and Credit." The Fed was particularly concerned about minority access to credit and the effects of recent mergers on lending to firms with less than $500-million in sales and less than 500 employees.
This understudied segment of banking, the middle-market, now accounts for over half the GDP and since 1970 has created two-thirds of the jobs compared to large firms.
Uzzi based his remarks on a study consisting of a national random sample of 2,400 medium-sized companies, fieldwork at 11 Chicago banks, and statistical analyses. His findings indicate that access to credit among these firms is embedded in the personal relationships they develop over time with their bankers. Such ties encourage bankers to seek more innovative deal structures and to favorably interpret ambiguous information about prospective performance.
"As the banker and the firm become friends, the bank is more motivated to go the extra steps," says Uzzi. "Through a social relationship, the bank is privy to more unique private information about how a firm went about getting its profit, or how it thinks about problems. This can lead to new ways to put debt together." It does not mean banks are less prudent or lend money below prime. Instead, Uzzi's study showed they split with clients "the mutual benefits created by social attachments and social networks, and share the potential profits that could be made from the loan."
Women and minorities are much less likely to have these social ties. "The scripts we use for building social attachments are easiest between white males; this disadvantages women and minorities," Uzzi says.
There is some evidence that banks are waking up to this. One Chicago bank has hired female "relationship managers" who are helping to attract female entrepreneurs. According to Uzzi, the bank has increased its loans to women by 20% over the past three years. African-American relationship managers, however, remain rare.
"Arm's-length ties," which afford firms market information freely available through public sources, are in and of themselves not nearly as effective for accessing credit, Uzzi's study found. But when a firm has both arm's-length and embedded social ties, "premium benefits" accrue.
Uzzi now plans to study how the large numbers of recent bank consolidations are affecting the way these social relationships operate. He will compare data from 1989, 1994, and 2000 to determine the impact of interest rates, new trends in credit scoring, and securitization of loans, as well as how access to capital is affecting the banks' ability to retain and build long-term relationships around other services.
Uzzi's findings appeared in a 1998 IPR working paper, "Embeddedness and the Making of Financial Capital: How Social Relations and Networks Benefit Firms Seeking Financing." The American Sociological Review will publish it in October.