Bankruptcy Litigation and Relationship Banking
Journal of Business Finance and Accounting, Forthcoming
Posted: 1 Dec 2012
Date Written: November 30, 2012
This paper analyzes how bankruptcy litigation affects the value of relationship banking. In our model, bankruptcy courts may make type 1 errors, i.e., they may declare that an insolvent firm is solvent; and they may make type 2 errors, i.e., they may declare that a solvent firm is insolvent. Our model provides four results. First, the cost of bank debt decreases when the probability that bankruptcy courts make type 2 errors increases. Second, the value of relationship banking increases when the probability that bankruptcy courts make type 1 errors increases. Third, the cost of credit intermediation decreases when the probability that bankruptcy courts make type 2 errors increases. Fourth, the diversification mechanism does not fully solve the delegated monitoring problem.
Keywords: bankruptcy litigation, bank monitoring, cost of bank debt, cost of credit intermediation, cost of financial distress, relationship banking
JEL Classification: G21
Suggested Citation: Suggested Citation