US Study Finds Loan Default Rates Lower in Rural Communities

While the ‘everyone knows everyone’ aspect of small towns has its drawbacks it may also have an upside in well-informed financial transactions, according to research by University of Kansas School of Business professor, Bob DeYoung.

He reports that small business loans originated by rural banks default much less frequently than loans originated by urban banks. More specifically, default rates are lowest for the most rural banks, in the most rural communities, and for banks that are located nearest to their customers, meaning that as ‘ruralness’ increases so does the success rate of bank loans.

DeYoung concludes that this is because rural banks have more access to so-called ‘soft information’ and personal relationships with customers than do urban banks, and because rural communities have higher levels of social capital – such as trust, shared networks and cultural similarities – than urban communities. Together, soft information and social capital overcome the fact that often there is little hard data on small business borrowers in rural communities.

“Everyone knows everyone in a small town and that leads to well-informed lending agreements between rural banks and rural businesses,” says DeYoung. “The more rural a bank and community, and the closer the bank is to the customer, the more likely the loan agreement will be successful. Why? Because personal relationships and local expertise matter, and those things can overcome the lack of hard information a lender might have about a small business client.”

He adds that commercial banks have always relied on both hard and soft information in deciding whether to make a business loan. But in rural communities, hard data about borrower creditworthiness can be hard to come by. For example, small rural businesses are less likely to have audited financial statements, which reduces the amount of hard data about their creditworthiness. Additionally, the resale market for fixed investments and specialised assets is thin, which makes it difficult to know the value of seized collateral in the case of loan default. However, while hard information is lacking in rural communities, soft information and social capital are not.

“The social and civic underpinnings of rural commerce are different from those in metro markets,” says DeYoung. “Rural communities are closer-knit than urban communities, and these personal informational networks extend into the rural business community as well. This gives rural banks a costless endowment of soft information about local businesses and entrepreneurs. Rural banks clearly use this information well, as evidenced by the low default rates on their loans.”

Will Rural Banks Survive and Thrive?

DeYoung used data on 18,000 US small business administration (SBA) loans originated between 1984 and 2001. These data provide a good test of the value of soft information and lending relationships because SBA borrowers tend to be smaller, younger and more credit-challenged than other small businesses, and because loans during this time period were originated largely before the advent of small business credit scoring and securitisation.

“There are two major trends that you’d think would mean the death of rural banks,” DeYoung says. “First, the banking industry continues to consolidate. Second, rural economies continue to become smaller and more volatile. And on top of this, nearly all rural banks operate below minimum efficient scale. So based on these factors, you’d think that rural banks would be closing their doors, right? But that’s not the case. In fact, 59% of remaining banks are located in rural counties, places that account for only 21% of the US population.

“For new and small businesses, access to credit is crucial to their survival. Of course, contracting with these businesses is risky for lenders, which means lenders must be expert in identifying the creditworthiness of these small businesses. Thus, a key question for researchers and policymakers is, ‘Which lenders, and which lending practices, are best at lending to new businesses?’ Our research suggests that rural community banks have a comparative advantage when it comes to lending to small businesses, and it’s because of soft information and social capital.”


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