The Dark Side of Bank-Firm Relationships: The (Market) Liquidity Impact of Bank Lending
42 Pages Posted: 15 Mar 2006
Date Written: March 2006
We study the trade-off between liquidity and monitoring implicit in the bank-firm relationship. By virtue of their lending activity, banks have privileged access to inside information about the companies and their monitoring role helps them mitigate the managers' risk-taking behavior. However, banks can also act as an "insider" and exploit this privileged information in the financial markets. We show that a more exclusive and geographically closer relationship with the lender increases the illiquidity of the stock of the borrowing firm and reduces both, its trading volume as well as its aggregate volatility. We explain the reduction in volatility in terms of lower incentives for the mangers to take on risk. The fact that firms borrowing from closer banks reward their mangers with less options- or equity-based compensation (as opposed to fixed compensation) supports our claim about reduced risk-taking. Simultaneously, however, a more exclusive relationship with the banks leads to a higher options- and equity-based compensation. Next, focusing on the effect upon firm value, we show that the extent of information asymmetry inherent in the lending relationship - captured here by the proximity to the banks - negatively affects firm value. On the other hand, the power of the bank derived from its role as a monitor - captured in our case by the exclusivity of the lending relationship - positively affects firm value. Overall, we illustrate a new "corporate governance" channel and our findings provide a fresh perspective on how lending relationships affect the firm.
Keywords: banks, geography, liquidity, monitoring, private information, relationship lending
JEL Classification: G30, G21, G32
Suggested Citation: Suggested Citation