This research investigates how SME performance, the typology of loans and the length and scope of relationships between small banks and SMEs affect the margin adjusted for the risk that each customer generates. After analysing 4285 firm-year observations from Finnish banks, the quality of a SME’s performance is found to be the major factor in explaining the risk-adjusted profitability of banks. However, the length and scope of a relationship and the loan dimensions also play an important role.

Research on relationship lending pays only marginal attention to the role of loan managers’ trust in the managers of SMEs. Trust literature suggests that trust reduces agency costs. Thus, trust is expected to be positively related to the amount of short-term credit granted and negatively related to SMEs’ risk of being credit constrained. Results from six banks characterised by a German culture and three banks characterised by an Italian culture suggest that this is indeed the case: SMEs that enjoy a high level of trust from loan managers obtain more credit and are less credit constrained.

Why are distortionary policies used when seemingly Pareto improvements exist? According to a standard textbook argument, a Pareto improvement can be obtained by eliminating the distortions, compensating the losers with a lump sum transfer, and redistributing the gains that are left over. We relax the assumption that winners know the losses suffered by the losers and show that the informationally efficient method of compensating losers may involve the use of seemingly inefficient (but informationally efficient) distortionary policies. The risk of overcompensating losers may make distortions informationally efficient, as there are points on the Pareto frontier where distortions are used.