So what do I get? The bank's view of lending relationships

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Abstract

While many empirical studies document borrower benefits of lending relationships, less is known about lender benefits. A relationship lender's informational advantage over a non-relationship lender may generate a higher probability of selling information-sensitive products to its borrowers. Our results show that the probability of a relationship lender providing a future loan is 42%, while for a non-relationship lender, this probability is 3%. Consistent with theory, we find that borrowers with greater information asymmetries are significantly likely to obtain future loans from their relationship lenders. Relationship lenders are likely to be chosen to provide debt/equity underwriting services, but this effect is economically small.

Introduction

The special nature of lending relationships has been the subject of extensive theoretical and empirical research in finance.1 While there is no precise definition of “relationship banking,” scholars broadly agree that if a financial intermediary's decision to supply various services to a firm is based on borrower-specific information that the intermediary collects over multiple interactions (over time as well as across multiple products), and further, if this information is proprietary (available only to the borrower and the intermediary), the intermediary is engaged in relationship banking (for a detailed discussion, see Berger, 1999, Boot, 2000). Existing theories predict that the establishment of strong lender-borrower relationships can generate significant benefits for the lender.2

Empirical evidence on the benefits of banking relationships has largely focused on documenting these benefits to the borrower. This literature can be broadly classified into two distinct approaches. The first approach uses indirect tests to establish the value of banking relationships. Specifically, James (1987) and Lummer and McConnell (1989) find a positive stock market reaction to the renewal of lending relationships and thereby establish the value-enhancement role of relationships to borrowers.3 The second approach attempts to estimate the effects of relationships on borrowers directly by examining the impact that such relationships have on the cost and availability of credit. This approach is best characterized by Petersen and Rajan (1994) and Berger and Udell (1995), who find, among other things, that the stronger (i.e., the longer the duration of) the relationship, the greater the credit availability and the lower the collateral requirements.

In contrast, the focus of our paper is on establishing the existence and the nature of the benefits of relationship banking from the perspective of the lender, a subject that has attracted far less attention in the literature. Indeed, relationship studies do not provide any guidance with respect to the sources of these benefits to lenders and how the value created by establishing such relationships is shared between lenders and borrowers.4 Thus, an important question is: what is the value of establishing a lending relationship to a lender (rather than a borrower)?

Existing theories of financial intermediation (see, e.g., Leland and Pyle, 1977, Diamond, 1984, Ramakrishnan and Thakor, 1984) emphasize the role of banks in generating information, for instance, through screening (Diamond, 1991) and monitoring (Rajan and Winton, 1995). Because relationship lending typically involves repeated interaction between a lender and a borrower over time, such interactions may generate “inside information” for the lender and reduce its cost of providing further loans and other services.5 To the extent that relationship lending produces reusable and proprietary information about the borrower, a possible benefit for the relationship lender is that it would be better placed to win future loan business and other fee-generating services from its relationship borrower.6 While the association between past lending relationships and future investment banking business has been examined recently by Drucker and Puri (2005) (for seasoned equity offerings), Yasuda (2005), and Burch et al. (2005) (for public debt underwriting), as far as we are aware, no study has examined the impact of lending relationships on the ability to win future loan business. Our paper provides tests that examine whether establishing a lending relationship translates into a higher probability of winning future lending as well as non lending business for a lender.

The central result of this paper is that strong past lending relationships significantly increase the probability of securing future lending and investment banking business. Holding all else constant, a bank with a prior lending relationship has more than a 40% probability of winning subsequent loan business from its borrower while a bank lacking such a relationship has only a 3% probability of being chosen to provide future loans. Consistent with theory, borrowers that suffer from greater information asymmetry (e.g., small, non rated firms) are more likely to use their relationship lender for future loans. Moreover, on average, a prior lender is almost twice as likely to be retained as the lead debt underwriter by its (loan) borrowers. While the impact of a prior lending relationship has a limited effect on the choice of a seasoned equity offering (SEO) underwriter, the existence of a past lending relationship is associated with almost a four-fold increase in the probability of being retained as a lead initial public offering (IPO) underwriter by a relationship borrower. To the extent that an increase in future lending and underwriting business is profitable, a greater likelihood of winning future business is a significant benefit to a relationship lender.

A number of recent studies examine the effect of past lending relationships on the choice of underwriter. Yasuda (2005) examines the impact of prior lending relationships on the choice of debt underwriter and finds that past lending relationships are associated with a significantly higher probability of securing the debt underwriting business. Ljungqvist et al. (2006) examine how analyst coverage affects a bank's ability to win both debt and equity underwriting business. While not the focus of their paper, they report that prior lending relationships are associated with a significantly higher probability of winning future investment banking business, especially for debt underwriting. Drucker and Puri (2005) focus exclusively on SEOs and report that “concurrent lending” (a loan six months before or six months after the issue) is associated with a higher likelihood of winning the underwriting business. Our results for underwriter selection are broadly similar to the results of these studies. Similar to Yasuda (2005) and Ljungqvist et al. (2006), we find that prior lending relationships are significantly associated with a higher probability of winning debt underwriting business. While we find that prior lending relationships are associated with a significantly higher probability of winning IPO business, our results for SEOs are not as significant as those reported by Drucker and Puri (2005). This difference in significance could arise in part due to our different methodologies in constructing the relationship measures, as their paper focuses on concurrent lending and underwriting. Also unlike Drucker and Puri, we explicitly control for market shares of potential underwriters in both the lending as well as the underwriting markets. Overall, our results are consistent with the findings of these recent studies, which show that prior lending relationships are associated with a significantly higher likelihood of winning underwriting business.

The remainder of the paper is organized as follows. We describe our main hypotheses in Section 2. Section 3 describes the data and sample selection process. We present the methodology and major results in Section 4. We conclude in Section 5.

Section snippets

Theoretical predictions and hypotheses

In this section we discuss testable predictions of existing theories of relationship lending and the main hypotheses that we test in this paper. The hypotheses that we test examine the benefits of relationship lending that accrue from the efficiencies in information production that a relationship lender enjoys. These hypotheses predict that a relationship lender is more likely to secure future business than is a non-relationship lender. We refer to these benefits collectively as higher business

Data and sample selection

To gain insights into these hypotheses we construct a unique database using three primary data sources, namely, the Loan Pricing Corporation Dealscan (henceforth, LPC) database,10 a merged CRSP and COMPUSTAT database, and the Securities Data Corporation (SDC) new securities issues database. As we describe later in the paper, the large number of mergers and acquisitions in the U.S. banking sector over our sample

Methodology and empirical results

In this section we describe the tests we employ to estimate the hypothesized (higher volume) benefits of relationships to lenders (Hypotheses H1, H2 and H3).

Conclusion

Our paper seeks to measure the direct benefits that a bank-borrower relationship generates for a lender. For lenders, the establishment of a relationship with a borrower allows for more efficient information production and processing in offering future loans and other information sensitive products. Consequently, a relationship lender should be more likely to secure the future business of its borrowers. We find that indeed, establishing a relationship with a borrower significantly increases the

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  • Cited by (0)

    Dahiya acknowledges the support of the Lee Higdon, Jr. Faculty Research Fellowship provided by McDonough School of Business. Srinivasan acknowledges the financial support of the Terry-Sanford research grant and the University of Georgia Research Foundation research grant during the course of this project. This is a substantially revised version of an earlier paper of the same title. This paper has benefited from suggestions and comments from the referee and seminar participants at the AFA 2005 meetings, American University, Drexel University, the DIW Berlin Conference on Bank Relationships, Credit Extension and the Macroeconomy, the Federal Reserve Bank of Chicago's Conference on Bank Structure and Competition, the Federal Reserve Bank of New York, Ohio State University and JFE-sponsored Conference on Agency Problems and Conflicts of Interest in Financial Intermediaries, the Federal Reserve Board of Governors in Washington DC, the Federal Deposit Insurance Corporation, the Financial Management Association 2004 meetings, George Mason University, Office of Controller of Currency, University of Michigan, University of Virginia, and Washington University. We thank Chris James, Allen Berger, George Benston, Christa Bouwman, Steven Ongena, Tim Loughran, and Greg Udell for their helpful comments.

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