Forgive but not forget: the behaviour of relationship banks when firms are in distress

By Larissa Schäfer

A new EBRD Working Paper studies whether relationship banks help firms in financial distress. Combining a new and direct measure of relationship lending with unique credit registry data, I examine the effect of relationship lending on ex-post loan performance. My findings demonstrate that the same firm is more likely to become temporary delinquent on a relationship-based loan relative to a transaction-based loan. Consistent with theory, relationship banks tolerate temporary bad results, yet extract rents in the long run, that is, they forgive but do not forget.

When firms are in distress, relationship banks adjust contract terms and allow drawdowns on credit lines and overdrafts but do not inefficiently roll over loans. Moreover, relationship banks are more likely to continue to lend to firms after past non-performance. Overall, the paper uncovers a new channel of how relationship lending serves as a liquidity insurance for firms in distress.