Bank Relationships, Earnings Quality and Cost of Debt: Cross-Country Evidence on Private Firms

Abstract

We expect that private firms choose a close relationship with a bank – often based on private information – in order to save on direct or proprietary costs of disclosure. For a large sample of bank relationships in 12 European countries, we find evidence that close bank relationships are associated with lower earnings quality as measured by higher absolute discretionary accruals and less timely loss recognition. This effect is stronger for firms with high proprietary costs. Further, we find that the strength of creditor rights intensifies the link between close bank relationships and earnings quality, while tax-book conformity moderates it. Finally, we show that close bank relationships directly tend to decrease the borrowing firms’ cost of debt by about 40 basis points on average. Indirectly, the cost of debt increase, because relationship lending goes along with lower earnings quality and relationship banks charge higher interest rates for poorer earnings quality than do other lenders. The findings suggest that relationship lending and financial disclosures can be considered as substitutes and that this relation is affected by the institutional framework. The paper also highlights that relationship lending implies a direct negative and an indirect positive effect on the borrowing firm’s cost of debt.