Private Bank Lending to Small Business in China: An Analysis of Default Rates

This study examines small business loans and default rates using a unique proprietary dataset from a private bank in China. As Chinese regulations preclude differential interest rates, alternative tools such as auditing, relationship length, and group lending are used to mitigate default risk. Although the audit process for small businesses in China is not of high quality compared to international standards, they still lower default rates as borrowers use audits as a positive signal of the firms’ likelihood of success. We also find that a longer relationship length reduces default risk as it likely increases the bank’s soft information regarding borrowers. Group lending is another popular mechanism for reducing default rates, especially for microfinance loans. While this strategy’s risk-sharing and monitoring aspects have been widely analyzed, we focus on a free rider problem using a game-theoretic model that suggests the optimal group size may be smaller than conventional wisdom suggests and empirically confirm this hypothesis.