The raison d’etre of banks may well be their role in mitigating informational asymmetries. Relationship banking is most directly aimed at resolving problems of asymmetric information. . . . Relationships play a critical role in investment banking as well and in the activities of nonbank financial intermediaries and private equity and debt markets.
Qualitative Asset Transformation:
A bank manages and absorbs risk (e.g., credit and liquidity risks) by issuing claims on its total assets with different characteristics from those encountered in its loan portfolio.
It is interesting to contrast the nature of asset transformation performed by commercial banks and investment banks.
Investment banks intercede in the building of a direct link between the market and the issuer.
Commercial banks internalize this relationship.
Why are bank’s assets illiquid?
The access to information is inherently linked to relationship banking and may point to a comparative advantage of banks.
Defining Relationship Banking
Bank invests in obtaining customer-specific information , often proprietary in nature; and
Bank evaluates the profitability of these investments through multiple interactions with the same customer over time and/or across products.
Distinguish from transaction lending – arm’s length / one at a time.
A company has a choice of how much of a relationship should be attached to its capital acquisition.
Relationships Have Many Applications
Companies may derive benefits from relationships that apply well beyond capital acquisition.
Even within the “banking context” these include:
Letters of credit (Including Standby Lines )
Some may see securitization as the beginning of the end for banks.
This ignores the credit enhancements provided by the issuing institution.
Provision of excess collateral
“Tranching” – putting ability on the line.
Relationships & Value
Relationship lending leaves room for flexibility and discretion in contracts that permits the utilization of subtle noncontractable information, thereby facilitating implicit long term contracting.
Relationship lending may include extensive covenants that allow for a better control of potential conflicts of interest.
Relationships & Value 2
Relationship lending may involve collateral (e.g., as in asset-based lending) that needs to be monitored. In fact, the need for such lending and monitoring may make the proximity of a relationship financier essential; otherwise, lending may not occur at all.
Relationship lending may allow the lender to take the long view – make a loan that is not profitable in the short term.
Costs of Relationships
Soft Budget Constraint Problem.
The key to understanding these problems is that when parties enter into a relationship, they will obviously attempt to position themselves to have an upper hand in future scenarios.
Costs of Relationships 2
The soft budget constraint idea is that a bank may find itself in a position of having so much at stake that it will take uneconomical steps to keep the borrower afloat.
This does not escape the borrower’s notice, so that the borrower does not spend enough resources attempting to avoid getting into such positions.
Costs of Relationships 3
The hold-up problem is a local monopoly problem. At a certain point in a relationship, the bank may be in a more powerful bargaining position than competitors.
Credit terms that restrict ex-post expropriation may solve this problem:
Solving Hold-up Problem
A long-term line of credit with a termination clause, which stipulates that the lender may terminate the relationship, but if it continues it, it must maintain the old terms, can balance the costs and benefits of the hold-up problem.
Competition & Relationships
In the early days of banking, the Gentleman Banker’s Code stipulated that banks would not compete for each others’ business.
Even today, the extent of competition seems to define the extent of relationship vs. transaction focus.