Guarantees, Borrower Quality, and Relationship Lending: a Note on the German Mittelstand

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]