The Dynamics of Credit Quality and Implications for The Pricing of Small Business Loans

Abstract

We analyze the implications of the dynamics of credit scores for small businesses; strategies for banks to maximize revenues; and Basel II minimum capital requirements on loan pricing for loans to small firms that do not have access to capital markets. Relating dynamic changes in the competitive environment to pricing decisions also provides a contribution to the literature. A theoretical model is developed to investigate the differences between relationship and transactional lending to small businesses in the context of these factors in the banking industry. The model demonstrates that in highly competitive markets, each type of lender occupies overlapping spaces, and can be simultaneously attractive to different types of borrowers if banks take advantage of their knowledge of the dynamics.