Effect of Information Asymmetry and Relationship Lending on Financial Intermediation of Small Firms in USA

The study applies a transaction costs framework to understand the economic behavior of financial institutions serving financial needs of small businesses in the U.S.A. Using survey data obtained from small- business- friendly financial institutions, hypotheses postulated by the Transaction Costs Theory were tested. This theory was also used to examine the potential for adoption of promising lender-borrower relationships to mitigate transaction costs incurred in financial intermediation. Measures of transaction costs and relationship lending variables were the opinions of key lending institutions towards performance of small businesses undertaking loan contracting in credit markets. These opinions were ranked on likert scales ranging from 1 to 6. An Ordered Multinomial Probit analysis was performed on the model of transaction costs and hypothesized determinants. Results show that a model of transaction costs of financial contracting that put into consideration the lender-borrower relationships had a greater explanatory power than one which ignored these relationships. The study concluded that lending technologies that incorporate relationship lending have potential of minimizing transaction costs especially in economies that experience severe information asymmetries. Key words: information asymmetry, lender-borrower relationships, relationship lending, small business, transaction costs Eastern African Journal of Rural Development Vol.20(1) 2004: 57-71