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commercial banks are the single most important source of external credit to small firms. Small businesses rely on banks not just for a reliable supply of credit, but for transactions and deposit services as well. Because of their needs for banking services on both the asset and liability sides of their balance sheets, small businesses typically enter into relationships with nearby banks. One of the reasons why the banking relationship is so important to small business finance is that banks can efficiently gain valuable information on a small business over the course of their relationship, and then use this information to help make pricing and credit decisions. The financial conditions of small firms are usually rather opaque to investors, and the costs of issuing securities directly to the public are prohibitive for most small firms. Thus, without financial intermediaries like banks it would simply be too costly for most investors to learn the information needed to provide the credit, and too costly for the small firm to issue the credit itself. Banks, performing the classic functions of financial intermediaries, solve these problems by producing information about borrowers and monitoring them over time, by setting loan contract terms to improve borrower incentives, by renegotiating the terms if and when the borrower is in financial difficulty, and by diversifying the risks across many small business credits. Some recent empirical research suggests that this characterization of the bank-small business borrower relationship is accurate. For example, as the relationship matures, banks typically reduce the interest rates charged and often drop the collateral requirements on small business loans.
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