In the banking literature, “relationship banking” is portrayed as being valuable to both banks and their client firms (Ramakrishnan and Thakor, 1984; Fama, 1985; Sharpe, 1990; Diamond, 1991). A bank provides the firm with loans and diverse financial services on the basis of a continuing relationship. It acquires information continuously about the firm and can thus intervene quickly and informally. Since the continuity of relationships allows the bank to have a competitive advantage in collecting information and monitoring the borrowing firm, it reduces informational asymmetries and the costs of financial distress for the client firm.
The advantages of relationship banking are known to be much greater in bank-centered financial systems, such as those in Germany and Japan, than in the capital-market-centered systems of Anglo Saxon countries (Aoki, 1990; Hoshi, Kashyap and Scharfstein, 1991; Kaplan, 1994; Kaplan and Minton, 1994; Kang and Shivdasani, 1995). In a bank-centered financial system, firms obtain most of their external financing from their main banks, although they maintain banking relationships with several banks. The main bank is particularly knowledgeable about the firm’s prospects. The main bank sometimes acts like a management consultant, providing advice to management and sending directors to the firm’s board in periods of financial distress to help the firm improve its performance.
However, relationship banking has a cost. As Rajan (1992) argues, because bank financing makes the bank well informed about the firm, it tends to make the firm hostage to the bank and hence enables the bank to extract rents. Further, an unexpected deterioration in bank durability imposes costs on client firms (Slovin, Sushka, and Polonchek, 1993; Gibson, 1995; Kang and Stulz, 2000). When a bank does poorly and suffers from a decreased ability to lend to a borrower, the client firm is adversely affected, since the firm loses the benefits of the durable bank relationship for the future. For example, Slovin, Sushka, and Polonchek (1993) examine the effect on client firm value of the near-failure of the Continental Illinois Bank and its subsequent rescue by the Federal Deposit Insurance Corporation (FDIC). They find that the bank’s impending insolvency and the subsequent FDIC rescue had negative and positive effects on client firm share prices, respectively.
These results imply that an unanticipated reduction in bank durability imposes significant costs on borrowers. On a macro-economy level, Bernanke (1983) examines the effects of the U.S. financial crisis during the period of the Great Depression on the real costs of credit intermediation. He shows that the failures of banks and other lenders reduce the efficiency of the financial sector in performing its intermediary functions and adversely affect the real economy. He argues that the difficulties of the banks during the Great Depreciation increased the costs of intermediation, making credit by the bank expensive and difficult to obtain. He also shows that bank failures are not caused by anticipations of future changes in aggregate output and refutes the opposite direction of causality.
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The Value of Durable Bank Relationships: Evidence from Korean Banking Shocks
