Passing the Parcel? Relationship Banking at the Onset of Financial Distress

Abstract

This paper explores banks' behaviour in the five years prior to a firm's financial distress. We construct a model of bank competition where new banks will often refinance loans that a firm's current banks do not want to renew. The model predicts that existing banks will be more frequently able to exit their loans if the firm has collateral or a good rating. Using bank–firm level credit data we test this model and document that indeed, banks with long standing relationships strategically terminate lending relationships at losses at the expense of less informed banks, well before those firms approach default. The number of banks continuously increases until about one year before the default, allowing inside banks that have been present in the firm’s capital for a long time to reduce their exposure. As predicted this effect is stronger for firms with a good credit rating prior to bankruptcy.