Ongena, S.R.G.

English

Research Papers in Economics

Door: Dr. S.R.G. Ongena
Benefits and Costs of Bank Relationships
INTRODUCTION
As a bank provides a set of services through time to a customer,
it gains substantial knowledge about the customer and its
financial needs. The bank can use this inside information to
establish a close relationship with the customer. This
relationship can, in turn, lead to benefits for both the customer
and the bank. For example, as a bank learns more about a
customer's payment pattern, it can tailor contracts to directly
suit the financial needs of the customer. A loyal customer will
be more willing to purchase all of its financial products from the
bank it trusts, aiding the bank in the marketing of profitable
new products. Indeed, as the Chase Manhattan motto suggests,
bankers often perceive the creation of a strong customer
relationship to be a core element of the services they offer.
Despite the perception of its importance, the value in a modern
economy of a close relationship between the bank and
customer is uncertain. Many of today's financial transactions
are executed via automated, anonymous markets that require
little relationship-building. The global trends toward deregu-
lation.disintermediation and securitizationappearto only have
accelerated the transition from relationship-intensive services
to more market- or transactions-oriented financial products.
Yet relationship-intensive financing may remain a fundamental
ingredient in the nurturing of developing firms and economies.
This primer briefly reviews the theoretical literature dealing
with the costs and benefits of bank relationships. As such, this
primer draws extensively on Ongena and Smith [2000], who
review recent empirical papers dealing with bank relationships.
Other introductions to this literature include Berlin [1996],
Grout [1997],Ongena[1999],andRivaud-Danset[l9%],among
others. Boot [2000] and Degryse and Ongena [1999] review the
importance of bank relationships for the competitive nature
and the structure of financial markets. Bhattacharya andThakor
[1993], Bernanke [1993],Scholtens [1993], and Freixas and
Rochet [1997], among others, contain broader coverage of
current research issues in banking. The rest of this primer is
organized into four sections. Section 2 begins by defining a
bank relationship. Section 3 discusses the benefits of a bank
relationship for the firm, while Section 4 lays out the potential
costs. Section 5 concludes.
Faces - 39DEFINITION OF A BANK RELATIONSHIP
In its most fundamental form, a bank is an institution whose
primary activities are the granting of loans and the taking of
deposits from the public. As an intermediary between individu-
als wishing to save and those that want to borrow, a bank is
strikingly similar to a securities market. The bank creates and
exchanges financial contracts to facilitate the movement of
funds between savers and borrowers. Historically speaking, a
bank has also provided liquidity and safety not available
through securities markets.
Indeed, a bank is expected to "lean against the wind" and
accommodate its debtors during difficult financial times. Such
flexibility is typically not available in an anonymous securities
market. To ensure its credibility as a savings institution^ bank
is also expected to quickly redeem deposits to savers on
demand. This ability to continuously offer liquidity to both
borrowers and savers also distinguishes a bank from "arm's-
length" securities markets (Rajan [1997]).
Providing financial flexibility requires a close association be-
tween the bank and each of its customers. Such an association
can be termed a relationship. In its most general form,0ngena
and Smith [2000] define a bank relationship to be the
connection between a bank and customer that goes beyond
the execution of simple, anonymous, financial transactions. The
benefits of a relationship may include the transfer of
proprietary information, a commitment to continue doing bu-
siness together through financially tough times, or the offer and
delivery of services at prices different from costs. A bank
relationship can be more specifically defined along two
dimensions. The first is time. The importance of a relationship
will depend on the length or duration of the interaction be-
tween the customer and bank. The second dimension is scope,
which pertains to the breadth of services offered by the bank
to its customer.
Maintaining a relationship often means that the customer and
bank are willing to make temporary sacrifices in favor of
obtaining future benefits. For example, a bank may attract
borrowers by offering up-front interest rates that are below-
cost, with the hope of charging higher rates to the same
customers later to recoup initial losses. Conversely, a firm may
be willing to initially accept above-cost interest loans, if a long
relationship promises a lower permanent rate in the future.
Such pricing decisions may influence the expected duration of
the bank relationship. The bank could also offer below-cost
loans to a customer, with the hope of recovering the losses
through customer purchases of other services from the bank.
Such pricing decisions then impact the scope of the
relationship.
BENEFITS OF A BANK RELATIONSHIP FOR THE FIRM
This section discusses four reasons for why bank relationships
improve financing possibilities, creates value, and ultimately,
may improve firm performance. Bank relationships improve
contracting flexibility between the customer and bank, reduce
agency problems through increased control by the bank,
enable reputation-building by the firm, and ensure
confidentiality of the financial transactions between the bank
and the firm.
First, armed with the information it privately observes, a bank
can exploit the length of a relationship to increase ex-ante loan
contracting flexibility (Boot and Thakor [1994]). As such, bank
can provide more complex and non-standard credit products
(Bernanke and Gertler [1985]). In addition, increased debt con-
tract flexibility may lengthen the firm's investment horizon (Von
Thadden [1995]). Indeed, periodic monitoring and the
possibility for the bank to grant or deny continuation may
induce firms to avoid myopic investment behaviour. Thaf is,
firms may avoid projects which only provide positive returns
later on. Such myopia may be present in public market con-
tracts (Porter [1992] makes this argument with respect to the
Anglo-Saxon reliance on equity markets).
Second benefit: bank relationships not only allow for more
flexible ex-ante contracting, they may also increase the ease
with which contracts can be renegotiated ex-post. For a firm
experiencing difficulty meeting contracted loan payments, a
bank can re-adjust the terms of the contract and either
accommodate the firm with new lending or refuse future
lending, conditional on actions taken by the firm during and
after the distress period. Thus, banks have the ability to exert
control over the management of firm assets, which may provide
the proper incentives to firm managers (Rajan [1992]). As such
bank debt seniority may play an important role in encouraging
the formation of ongoing bank-firm relationships. As senior
creditors, banks will benefit first from additional investment in
a distressed firm. Hence banks will have incentives to build
relationships that allows them to determine the value of such
investment (Longhofer and Santos [2000]).
Third advantage: since repeated lending from a bank provides
credible certification of payment ability, borrowers may
establish a relationship in order to gain a reputation for making
timely loan payments. Reputational concerns can therefore
influence a firm's choice between bank financing and arm's-
length financing. Reputation-building through bank
borrowing may serve as a means for establishing enough
credibility to eventually borrow through public markets (Dia-
mond [1991]). Higher quality firms care most about
establishing a reputation and find it therefore most costly to
Facesdefault on a monitored bank loan. Eventually, a high quality
firm's reputation grows to such an extent that the cost of
default - through loss of reputation - is so high that the firm can
seek unmonitored, public debt.
Finally, bank relationships also enable a firm to obtain financing
without disclosing valuable information to the public
(Campbell [1979]). The confidentiality of bank lending may
protect proprietary information and facilitate screening and
monitoring. Improved confidentiality encourages investment
in research and development (R&D), when public disclosure of
accumulated R&D knowledge creates a free-rider problem
(Bhattacharya and Chiesa [1995]). In addition, high-quality
firms will choose bilateral bank financing to avoid information
leakage through multilateral or public financing which may
trigger aggressive behavior of product market competitors
(Yosha [1995]), unless firms can control how much information
is collected by the banks (Von Rheinbaben and Ruckes [1998]).
THE DARK SIDE OF BANKING
The ability for a bank to privately observe proprietary
information and maintain a close relationship with its customer
can also impose important costs on the customer. Long-term
bank relationships arise in a competitive loan market because
an incumbent bank has the ability to offer only above-cost
loans to its best customers and holdup customers from
receiving competitive financing elsewhere (Sharpe [1990],
Fischer [1990], Von Thadden [1998]). The incumbent bank gains
this monopoly power through its informational advantage over
competitors. A high-quality firm that tries to switch to a
competing uninformed bank is pooled with low-quality firms
and is offered an even worse, break even interest rate. Other
holdup costs arise because the bank has often the power to
withdraw financing when it perceives the firm to be
inadequately managing the financed assets. This degree of
control may reduce ex-ante the incentives of the firm managers
to exert effort in managing the assets (Rajan [1992]).
The extent to which any one bank can exploit an information
monopoly is unclear. Sharpe [1990] predicts that an incumbent
bank's monopoly power will be abated by accurate public
signals of the firm's ability to pay (i.e. everybody may be able to
observe that the firm is prospering). Similarly, the fact that the
same inside bank is willing to provide fresh loans may increase
the firm's reputation for payment ability, allowing for easier
access to public markets, and hence less reliance on bank
borrowing (Diamond [1991 ]). The bank's monopoly power may
also be capped by the potential for moral hazard problems
associated with asset substitution as the bank charges higher
interest rates (Schmeits [1997]): i.e. higher interest rates may
Berlin, M., 1996, For Better and For Worse: Three Lending Relationships, Federal Reserve Bank of Philadelphia Business Review November, 3-12.
Ba-nanke, B.S., 1993, Credit in the Macroeconomy, Federal Reserve Bank of New York Quarterly Review 18,50-70.
j .
Bdrnanke, B.S. and M.Gertler, 1985, Banking in General Equilibrium, University of Wisconsin Press, Madison.
Bhattacharya, S. and G. Chiesa, 1995, Proprietary Information, Financial Intermediation, and Research Incentives, Journal of Financial Intermediation 4,328-357.
Bhattacharya, S. and A.V.Thakor, 1993, Contemporary Banking Theory, Journal of Financial Intermediation 3,2-50.
Boot, A.W.A., 2000, Relationship Banking: What Do We Know?, Journal of Financial Intermediation 9, Forthcoming.
Boot, A.W.A. and A.V.Thakor, 1994, Moral Hazard and Secured Lending in an Infinitely Repeated Credit Market Game, International Economic Review 35,899-920.
Campbell, T.S., 1979, Optimal Investment Financing Decisions and the Value of Confidentiality, Journal of Financial and Quantitative Analysis 14,232-257.
Chemmanur, TJ.and P. Fulghieri, 1994, Reputation, Renegotiation and the Choice between Bank Loans and Publicly Traded Debt, Review of Financial Studies 7,
475-506.
Degryse, H. and S. Ongena, 1999, Bank Relationships and the Structure of Financial Markets, Mimeo, K.U. Leuven.
Diamond, D., 1991, Monitoring and Reputation: the Choice between Bank Loans and Privately Placed Debt, Journal of Political Economy 99,689-721.
Fischer, K., 1990, Hausbankbeziehungen als Instrument der Bindung zwischen Banken und Unternehmen - Eine Theoretische und Empirische Analyse, PhD
Dissertation, Universittat Bonn.
Freixas, X. and J.C. Rochet, 1997, Microeconomics of Banking, Massachusetts Institute of Technology Press, Cambridge MA.
Grout, J., 1997, On Banks, in Managing Banking Relationships, G. Leahy, Eds. 57-67.
Houston, J.F. and S. Venkataraman, 1994, Information Revelation, Lock-In, and Bank Loan Commitments, Journal of Financial Intermediation 3,355-378.
Longhofer, S.D. and J.A.C. Santos, 2000, The Importance of Bank Seniority for Relationship Lending, Journal of Financial intermediation 9, Forthcoming.
Ongena, S,, 1999, Lending Relationships, Bank Default, and Economic Activity, International Journal of the Economics of Business 6,257-280.
Ongena, S. and D.C. Smith, 2000, Bank Relationships: a Survey, in The Performance of Financial Institutions, P. Marker and S.A. Zenios, Eds. Forthcoming.
Padilla, A J. and M. Pagano, 1997, Endogenous Communication among Lenders and Entrepreneurial Incentives, Review of Financial Studies 10,205-236.
Petersen, M.A. and R.G. Rajan, 1995, The Effect of Credit Market Competition on Lending Relationships, Quarterly Journal of Economics 110,406-443.
Porter, M.E., 1992, Capital Disadvantage: America's Failing Capital Investment System, Harvard Business Review 65-82,
Rajan, R.G., 1992, Insiders and Outsiders: the Choice between Informed and Arm's-length Debt, Journal of Finance 47y1367-1400,
Faces - 41_The strong Relationship with a Customer makes a Difference
between Succes or failure for Banks
drive the firm to undertake more risky projects.
The information monopoly rents of the inside bank may also be
contained by loan commitments (Houston and Venkataraman
[1994]), or eroded through market driven information leaks. For
example, loan officers may jump ship and join a competitor
bank, taking with them valuable customers and inside
information about those customers. In addition, banks
sometimes voluntarily or with a little regulatory nudging
establish information-sharing sources like credit registers
(Padilla and Pagano [1997], Van Cayseele, Bouckaert and
Degryse [1994]). Such registers will limit the information
monopoly of each individual bank to the extent that credit
information is reported accurately and timely.
Another seemingly simple solution to the holdup problem is for
a firm to establish more than one inside bank relationship and
have the banks compete away the monopoly rents. Such
competition can be a "double-edged sword" however (Rajan
[1992]). Any outside lender that competes with an existing
inside bank by offering a lower interest rate at an interim stage
of financing will suffer from a winner's curse problem. The
inside-bank will offer a competitive bid for good firms while
allowing bad firms to take the outside lender's offer (a similar
point is made by Von Thadden [1998]). When competition
endues between more symmetrically informed banks,
monopoly rents can be eliminated, but only at the expense of
reduced control over firm investment behavior. Hence
competition at the outset between an insider and outsider has
the benefit of reducing the monopoly rent one bank can
charge, but also reduces its ability to control the investment
behavior of the firm. Moreover, credit market competition may
well reduce the availability of credit to firms that benefit most
from relationship lending (Petersen and Rajan [1995]).
The costs arising from holdup problems may also be tempered
by the bank's desire to build a reputation for refraining from
extracting monopoly holdup rents (Sharpe [1990]). Such a
reputation may be valuable in attracting future customers.
Banks wishing to establish a reputation for financing
productive firms, may monitor the firm more intensively, which
in turn leads to more efficient continuation decisions in
renegotiations (Chemmanur and Fulghieri [1994]).
CONCLUDING REMARKS
Hence according to both practitioner beliefs and recent
theoretical papers in banking, it is through the close
relationship formed with its customers that a bank
distinguishes itself as an independently important, functioning
intermediary between savers and users of funds. A relationship
can facilitate the screening and pruning of loan customers,
reveal information important to establishing future credit
terms, and may be an integral part of controlling the behavior
of firm managers. The strength of a relationship can be
measured by the duration of the relationship through time,and
by the scope of services offered by the bank to it customer.
Relationships may offer benefits to the firm, but can also
impose holdup costs. To empirically determine in which market
settings and for which type of firms, relationships are on net
beneficial may be a rich avenue for future research.
Tfcaufaf a r&^ to fa departBmentd finance at fa Faculty of Ecanaaicr
and Business Admmktration of Titbwg University. •. .,;
'Note: Corporate Sloflon, Oxu* Monhortan Bank ' ;..-.:
 iv
; vs
Rajan, R.G., 1997, Is there a Future in Banking? Towards a New theory of the Commercial Bank, Journal of Applied Corpora te Finance
Rivaud-Danset, D-, 1996, Les Contrats de Credit dans une Relation de Long Terrne: de la Main Invisible a la Poignee de Main, Revue EconomiqueQ, 937-962.
Schmeits, A., 1997, Discretion in Bank Contracts and the Firm's Funding Source Choice Between Bank and Financial Market Financing,Afimeo, Til burg University,
Scholtens, LJ.R-, 1993, On the Foundations of Financial Intermediations Review of the Literature, Kiedit and Kapiwl 26,112-141.
Sharpe, SJV., 1990, Asymmetric Information, Bank Lending and Implicit Contracts: a Stylized Model of Customer Relationships, Journal of Finance 45,1069-1087,
Van Cayseele, P., J. Bouckaert and H. Degryse 1994, Credit Market Structure and Information Sharing Mechanisms, in Studies in Industrial Organlzation.V.
Witteloostuyen, Eds. 129-143.
von Rheinbaben,J. and M.Ruckes, 1998, A Firm's Optimal Number of Bank Relationships and the Extent of Information Disclosure,Mimeo, University of Mannheim.
von Thadden, E.L., 1995, Long-term Contracts, Shori-term Investment, and Monitoring, Review of Economic Studies 62,557-575.
von Thadden, E.L, 1998, Asymmetric Information, Bank Lending, and Implicit Contracts: the Winner's Curse,M'meo, University of Lausanne (DEEP).
Yosha, O., 1995, Information Disclosure Costs and the Choice of Financing Source, Journal of Financial Intermediation 4,3-20.
Foces - 43

Benefits and costs of bank relationships.

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics