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Influence of heuristics in bank managers' lending decisions to small businesses

Mahmood, Rosli (1995) Influence of heuristics in bank managers' lending decisions to small businesses. Banker's Journal Malaysia (116). pp. 35-37. ISSN 0126-9534

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Traditionally, banks are the major source of external finance for small businesses.The bank funds are needed to finance the day-to-day operations, purchase of capital equipment, and building needs.The small businesses do have access to the capital market, especially where equity finance is concerned,and thus rely heavily on bank loans for both short- and long-term needs.When granting loans to small businesses, bankers make decisions under conditions of uncertainty and asymmetry of information (Binks et al, 1992) Under these conditions, one party has certain pieces of information that have a material effect on a contract, but not the other party, and such a situation can give rise to a twin problem of moral hazard and adverse selection.In the former situation, the issue arises where the action of a small business borrower is not directly observable by the banker once he or she obtains the loan.This borrower may use the funds for other purposes which are personally profitable, but may be detrimental to the banker.In an adverse selection situation, a banker cannot distinguish between the good risk and the bad risk borrowers.A small business owner when approaching the bank for a loan has always an informational advantage over the banker, which leads him (the business owner) to overstate the soundness of his business proposition in relation to the funding sought.This problem sometimes affects the willingness of banks to enter into contracts to supply the needed funds to small businesses.The problem of adverse selection often lead bankers to commit errors in their decisions on lending to small businesses. Deakins and Hussain (1994) categorise the adverse selection as Type I and Type II errors. Type I error is where a banker turns down a good business proposition which turns out to be a success, while Type II error is where a banker accepts a proposition which turns out to be a business failure.Bankers may be concerned only with avoiding Type II error and not Type I, as the latter will not affect them unless the banks fail to achieve their targets.This partly explains why some small business propositions which have high potential for growth and profitability are turned away by the banks.At the branch level, bank managers often make their decisions on small business applications against a background of rules and instructions from their head offices (Fletcher, 1995). There are many variables which influence the rules and the work environment, and affect the lending decision.The decision on lending to small businesses is thus a process of interaction between the rules and a manager's experience.The extent of variability is affected by the interpretation of the rules and accountability in interpreting these rules.One extreme is the strict interpretation of the rules, which is a product of their rigour and detail. Where they lack detail or are imprecise, then the decision will depend on the interpretation, accountability and level of ambiguity.At the other extreme, the decision is made on the complete use of one's own experience and attitude and depends on the conviction of the value of the bank manager's own experience-Furthermore, because of the asymmetry of information in lending to small businesses.some elements of qualitative and intuitive analysis are required In decision-making.This paper attempts to discuss the influence of heuristics or intuition in the bank managers' lending decisions on small businesses, and its implication on the availability of funds to the small business sector in Malaysia.

Item Type: Article
Subjects: H Social Sciences > HG Finance
Divisions: College of Business
Depositing User: Prof. Dr. Rosli Mahmood
Date Deposited: 23 Jul 2013 08:02
Last Modified: 23 Jul 2013 08:02
URI: http://repo.uum.edu.my/id/eprint/8596

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