Businesses were severely impacted by the credit contraction resulting from the Lehman Brothers collapse in 2008 and its aftermath. However, companies that had built strong bonds with select lending partners fared better during the credit crunch, experiencing a more favourable impact than others, according to a 2013 Bank for International Settlements study1. The depth of these banking relationships held a key to their impact.
It wasn't just a matter of how long these partnerships had endured; it also hinged on the depth of these connections, and it became apparent that banks were more inclined to help firms with whom they had a longstanding history and had a vested interest in the borrower’s survival.
This conclusion was echoed by a 2018 Cass Business School study, which showed relationship lending proved particularly beneficial during economic downturns by mitigating credit constraints for borrowers2. This positive effect was particularly pronounced for smaller, less transparent firms and in regions that experienced severe economic downturns. Additionally, relationship lending helped cushion the impact of a downturn on firms.
Given its advantages during a crisis, it would be interesting to note how relationship banking endures during more routine but nonetheless impactful events, such as changes in monetary policy.
A 2019 study by Prasanna Tantri, Associate Professor, Finance and Executive Director - Centre for Analytical Finance, and Krishnamurthy Subramanian, Professor, Finance, Indian School of Business; and Abhishek Bharadwaj, Assistant Professor, Tulane University, examined data on whether such unique banking relationships ameliorate or exacerbate the effects of monetary policy shocks for borrowers compared with firms that maintained non-exclusive and diversified banking relationships.
It is a universally accepted fact that banks' interactions with businesses are vital for economic stability. Firm balance sheets can magnify or reduce policy effects. Relationship banking adds a new variable to these changes, affecting how policy shocks impact credit demand for companies relying on a single bank or firms that rely on multiple banks.
Relationship bankers invest substantial time in understanding their clients, effectively addressing information gaps that usually hinder financial transactions. Hence, companies that have relationship banks may possess a certain resilience to monetary policy shocks, which their peers who focus on only transaction-specific banking relationships may lack.
Bank Lending
A 2004 paper by the Asian Development Bank delved into the advantages and disadvantages of bank debt compared to public debt, specifically corporate bonds, from the perspective of relationship banking. It demonstrated that bank debt offers flexibility by allowing for the renegotiation of terms, reducing agency costs, and granting creditors control over borrower decisions3. Additionally, the announcement of bank debt can positively impact stock returns. However, the paper also noted that bank debt comes with higher intermediation costs and can potentially discourage investment incentives. Further, it can lead to an "information monopoly" problem, making it challenging for borrowers to switch lenders.
While the Asian Development Bank paper primarily focused on Japanese banks, relationship banking in India is found to be more prevalent among small firms and small banks. In contrast, larger firms tend to maintain relationships with multiple banks and are less inclined towards exclusive banking arrangements. Relationship bankers’ deeper understanding of the borrower can help them better navigate the impacts of events such as monetary policy changes.
Monetary Policy and Bank Relationships
The analysis of how changes in monetary policy affect the borrowing habits of businesses revealed that a 1% increase in the average Cash Reserve Ratio (CRR) is associated with a 1.8% decrease in the ratio of bank borrowing to total borrowing.
At the same time, it was found that companies that exclusively used one bank were not as sensitive to these changes in monetary policy, experiencing only a 0.7% decrease in the ratio of their bank borrowing to total borrowing. This finding goes against the widely held assumption that firms with a single banking partner are more affected by policy shifts.
Additionally, the authors proved that firms relying on just one bank tended to borrow less from banks than those with multiple banking relationships.
A 2015 paper analysing the benefits of relationship lending concluded that strong relationships generally benefited borrowers, but the outcomes varied depending on specific relationship dimensions4. Factors such as time, exclusivity, and cross-product synergies were associated with lower loan rates and higher credit volume. However, borrowers in exclusive relationships tended to provide more collateral, and those in close physical proximity to their lenders faced higher interest rates. The results indicated that the advantages of relationship lending extended beyond improved credit availability for firms. Banks made trade-offs between the costs and benefits of different relationship dimensions and lending terms.
The paper further states that this conclusion aligned with previous research showing that companies facing challenges in accessing debt markets due to factors like their size or lack of transparency often rely heavily on relationship banking.
The authors examined how relationship banking influences companies’ reactions to monetary policy changes. One crucial aspect they investigated was the substitution between bank credit and non-bank credit. They found that companies with exclusive banking relationships were less affected by monetary policy changes than those with multiple banking options. The researchers showed that relationship banking-focused companies experienced a 61% lower impact from monetary policy shocks than their transaction banking counterparts. However, these single banking companies faced challenges in replacing bank loans with non-bank sources due to information differences.
On examining the effects of tightening and loosening of CRR rates on companies borrowing from banks, it is clear from the research that a 1% increase in the average CRR leads to a 1.7% reduction in bank borrowing for companies with multiple banking relationships, while conversely triggering a 2.1% increase in bank borrowing for companies with exclusive banking relationships. This proves that having a single banking partner, regardless of monetary policy cycles, offers advantages but may pose limitations during periods of monetary expansion.
These observations are economically significant as they prove that even a one percentage point change in the average CRR could lead to changes in bank debt issuance, potentially affecting companies significantly.
The 2013 BIS study referred to earlier concluded that relationship banking played a crucial role in mitigating financial crises by helping profitable firms maintain access to credit during challenging economic times, thereby reducing the adverse effects of credit shortages. However, the effectiveness of relationship banks during crises depended on the amount of excess equity capital they held in preparation for such events. Banks with larger capital cushions could perform their relationship banking role more effectively.
The BIS analysis suggested that encouraging more firms to establish long-term banking relationships and incentivising relationship banks to maintain larger equity capital buffers before crises could positively impact corporate investment and economic activity, mitigating the severity of economic downturns5.
The Trust Fall Test
The researchers put forth key insights into the connection between monetary policy, bank interactions, and corporate loans. They have highlighted the impact of even slight changes in the CRR on companies’ debt structure, thus emphasising the need for companies to closely track and adapt to monetary policy fluctuations.
The team’s conclusions challenged the belief that companies tied to a single bank are more vulnerable to policy shifts, suggesting these corporate entities exhibit greater resilience, especially considering they are smaller than their peers.
Consequent to these findings, policymakers should promote long-term banking relationships and incentivise banks to maintain adequate capital.
The research provides a deep understanding of banks' role in influencing economic outcomes and highlights the importance of preserving relationship banking advantages in a rapidly evolving financial environment.
Featured Faculty
Krishnamurthy Subramanian
Prasanna Tantri
