This paper assesses different organizational forms in terms of their ability to generate information about investment projects and allocate capital to these projects efficiently. A decentralized approach–with small, single-manager firms–is most likely to be attractive when information about individual projects is “soft ” and cannot be credibly transmitted. Moreover, holding fixed firm size, soft information also favors flatter organizations with fewer layers of management. In contrast, large hierarchical firms with multiple layers of management are at a comparative advantage when information can be costlessly “hardened ” and passed along within the hierarchy. As a concrete application of the theory, the paper discusses the consequences of consolidation in the banking industry. It has been documented that when large banks acquire small banks, there is a pronounced decline in lending to small businesses. To the extent that smallbusiness lending relies heavily on soft information, this is exactly what the theory would lead one to expect.

The distance between small firms and their lenders is increasing, and they are communicating in more impersonal ways. After documenting these systematic changes, we demonstrate they do not arise from small firms locating differently, consolidation in the banking industry, or biases in the sample. Instead, improvements in lender productivity appear to explain our findings. We also find distant firms no longer have to be the highest quality credits, indicating they have greater access to credit. The evidence indicates there has been substantial development of the financial sector, even in areas such as small business lending. SMALL BUSINESS LENDING HAS HISTORICALLY been very costly, because of the paucity of information about small firms and the high costs of the personnel required to obtain even that information. Information about small businesses is thought to be “soft, ” and has to be collected by lenders over time through relationships with firms ~see Berger and Udell ~1995!, Petersen and Rajan ~1994!!. 1 If these descriptions of small businesses are accurate, they

Theories based on incomplete contracting suggest that small organizations may do better than large organizations in activities that require the processing of soft information. We explore this idea in the context of bank lending to small firms, an activity that is typically thought of as relying heavily on soft information. We find that large banks are less willing than small banks to lend to informationally “difficult ” credits, such as firms that do not keep formal financial records. Moreover, controlling for the endogeneity of bank-firm matching, large banks lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively. All of this is consistent with small banks being better able to collect and act on soft information than large banks.

Abstract: This paper examines patterns of integration among manufacturers and retails, using data from a survey of footwear manufacturers in Mexico. The property rights framework, developed in papers by Grossman, Hart and Moore, is differentiated from the standard empirical transactions cost framework. In the context of this industry, the most relevant distinction between the two frameworks is that the property rights framework addresses both the benefits and costs of integration, while the transactions cost framework focuses only on variation in the benefits of integration. We show that the costs of integration are highest where the retailer’s non-contractible investment has an important effect on the overall profits from the relationship. Consistent with the property rights framework, the data suggest that integration is less likely in these circumstances.

This paper presents theory and evidence on horizontal industry structure, focusing on situations where plant-level scale economies are small and market power is not an issue. At issue is the question: what makes industries necessarily fragmented? The theoretical model distinguishes between the structure of brands and firms in an industry by examining trade-offs associated with affiliation and integration, andhow they are affected by the contracting environment. I show how contractual incompleteness can lead industries to be necessarily fragmented. I also show that improvements in the contracting environment will tend to lead to a greater concentration of brands, but whether they lead industries to be more or less concentrated depends on what becomes contractible. I then discuss the propositions generated by the model through a series of case study examples.

The U.S. banking system has long had a multitude of small institutions. This characteristic of the industry has been shaped by a number of factors. The dual banking system—that is, the coexistence (since the end of the Civil War) of both federal and state chartering—has fostered the creation of small banks, and this effect was reinforced by chartering regulations at both the national and state levels that were frequently permissive. In addition, the fear of concentration, as well as efforts to keep local markets free of outside competition, led many states to impose longstanding limits on branching, and this legacy of unit banking helped swell the numbers of small banks, particularly in the Midwest. The lack, until fairly recently, of the technology necessary for creating very large banking organizations was another factor contributing to the multiplicity of small banks. Of course, during the last quarter of the twentieth century the requisite technological advances occurred at the same time that legal impediments to branching were being gradually removed. Thus, for the last decade of the century in particular, the industry saw a great deal of consolidation, much of it involving community banks, whose * The authors are all with the Division of Insurance and Research of the Federal Deposit Insurance Corporation: Tim Critchfield is a senior financial analyst; Tyler Davis, a research assistant; Lee

Abstract: Theories based on incomplete contracting suggest that small organizations may have a comparative advantage in activities that make heavy use of soft information. We explore this idea in the context of bank lending to small businesses. We find that large banks are less willing than small ones to lend to informationally “difficult ” credits, such as firms that do not have financial records. Moreover, controlling for the endogeneity of bank-firm matching, large banks lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively. All of this is consistent with small banks being better able to collect and act on soft information than large banks. The opinions in this paper do not necessarily reflect those of the Federal Reserve Board or its staff.

This paper explores di¤erent organizational forms in terms of their ability to generate information about investment projects and allocate capital to these projects e¢ciently. A decentralized approach-with small, single-manager …rms- is most likely to be attractive when information about individual projects is ”non-veri…able ” and cannot be credibly transmitted. Moreover, holding …xed …rm size, non-veri…able information also favors ‡atter organizations with fewer layers of management. In contrast, large hierarchical …rms with multiple layers of management are at comparative advantage when information can be costlessly ”veri…ed ” and passed along within the hierarchy. As a concrete application of the theory, the paper discusses the consequences of consolidation in the banking industry. It has been documented that when large banks acquire small banks, there is a pronounced decline in lending to small businesses. To the extent that small-business lending relies heavily on non-veri…able information, this is exactly what the theory would lead one to expect. We have received helpful comments from Ron Anderson and Olivier renault (LSE); Financial Support of the Belgian French Community is gratefully acknowledged 1 1

Abstract: Theories based on incomplete contracting suggest that small organizations may do better than large organizations in activities that require the processing of soft information. We explore this idea in the context of bank lending to small firms, an activity that is typically thought of as relying heavily on soft information. We find that large banks are less willing than small banks to lend to informationally “difficult ” credits, such as firms that do not keep formal financial records. Moreover, controlling for the endogeneity of bank-firm matching, large banks lend at a greater distance, interact more impersonally with their borrowers, have shorter and less exclusive relationships, and do not alleviate credit constraints as effectively. All of this is consistent with small banks being better able to collect and act on soft information than large banks. The opinions expressed in this paper do not necessarily reflect those of the Federal Reserve Board or its staff. Research support from the following sources is gratefully acknowledged: the National Science Foundation (Rajan, Stein), and the George J. Stigler Center for Study of the State and Economy (Rajan). Thanks also to seminar participants at Yale University and the Federal Reserve Bank of New York, and to