Relationship Lending and Firms’ Leverage: Empirical Evidence in Europe

• Date: 01 September 2017
• DOI: http://doi.org/10.1111/eufm.12109
• Published date: 01 September 2017

Relationship Lending and Firms’

Leverage: Empirical Evidence in

Europe

Roberto Guida

International University at Rome, Via G. Baracconi 5/A, 00161 Rome, Italy

E-mail: r.guida@unint.eu

Valentina Sabato

LUMSA University of Rome, Rome, Italy

E-mail: v.sabato@lumsa.it

Abstract

Using a novel measure of relationship lending based on the kind of information

banks use to assess borrowers, we investigate the role of relationship lending in

firms’capital structure. Using a unique dataset of European manufacturing firms,

we measure relationship lending based on three dimensions (closeness, soft

information, exclusivity) and relate them to firms’leverage. Overall our results

support the hypothesis that supply factors matter. We find that the actual use of soft

information increases leverage and only firms without soft information-intensive

relationships increase their leverage through multiple relationships. However, the

effect of relationship lending on leverage varies across countries.

Keywords: relationship lending, soft information, cap ital structure, leverage,

financial systems

JEL classification: D45, G15, G21, G32

1. Introduction

In this paper, we use a novel relationship lending measure based on the kind of information

banks use to assess borrowers’creditworthiness to investigate the role of relationship

lending in firms’capital structure. In particular, we are interestedin determining whether

having relationships with banks that are able to gather relevant soft information about the

prospects and creditworthiness of borrowers affects firms’leverage ratios.

Relationship lending is a common practice in credit financing. According to the 2014

‘Survey on the Access to Finance of Enterprises in the Euro Area’(European Central

The authors are grateful to two anonymous referees and John Doukas (the Editor) for their

helpful suggestions. Furthermore we would like to thank Stefania Cosci and Valentina

Meliciani for many comments and discussions.

European Financial Management, Vol. 23, No. 4, 2017, 807–835

doi: 10.1111/eufm.12109

© 2016 John Wiley & Sons, Ltd.

Bank, 2014), bank-related products are the most relevant sources of financing for small-

and medium-sized enterprises (SMEs) in the eurozone, whereas market-based sources

are less often reported as being relevant; thus, banks are the main actors and banking

relationships the main instruments in financing for SMEs in Europe. However, in the last

few decades, the European financial system has witnessed a process of transformation

that has moved it somewhat toward an arm’s-length system, stimulating and promoting

competition between financial institutions.

1

To meet Basel II capital requirements, many

banks have been adopting new screening technologies, based on standardised internal

rating models that use ‘hard information’(quantitative information such as credit history,

balance sheet data, rating and scoring), that have progressively substituted pre-existing

technologies that are also based on ‘soft information’(qualitative information consisting

mainly of words expressing subjective judgements, opinions and perceptions). These

recent trends in the European financial markets, along with better information

processing, more sophisticated rating tools and the growth of the securitisation market,

have pushed banks to reduce their relationship lending activities. Hence, strong bank-

firm relationships seem to become less important (Issing, 2003; Memmel et al., 2008).

How does this impact on firms’ability to finance their investments, especially for firms

that theory predicts may be credit constrained?

Since the work of Modigliani and Miller (1958), the capital structure literature has

tried to answer Myers’(1984) ‘capital structure puzzle’. In this regard, different theories

that give alternative explanations for firms’capital structure decisions have been

developed. The empirical literature, which mainly tests the validity of the alternative

theories, has examined the role of several firm-specific factors, under the implicit

assumption that firms are not credit constrained (Faulkender and Petersen, 2006).

However, the same market frictions that make capital structure choices relevant also

imply that firms may be unable to raise sufficient capital to fund all of their good projects;

i.e., firms may be rationed by their lenders (Stiglitz and Weiss, 1981). In this case, supply

factors become relevant: a firm’s capital structure may depend on the amount of credit

available to the firm.

Asymmetric information and agency cost problems may be overcome by lenders that

specialise in collecting information about borrowers. By interacting with borrowers over

time and across different products, the financial intermediary may be able to mitigate the

information asymmetry that is the cause of the market failure, and these financial

relationships have been empirically demonstrated to be important in relaxing capital

constraints. In particular lending relationships should be most valuable where the

information about a firm and potential investment opportunities is most uncertain (SMEs

and innovative firms).

2

Whenever the amount of soft information produced about a firm

1

Rajan and Zingales (2003) classify financial systems as relationship-based and arm’s-length

systems rather than bank- and market-based systems. There is not an exact coincidence

between the two classifications, although they overlap to some extent. On the validity of the

distinction between bank- and market-oriented systems, see also Schmidt and Tyrell (1997).

2

Although the literature suggests that banks have an advantage in financing informationally

opaque firms by screening and monitoring borrowers, banks actually finance a smaller

fraction of total debt when adverse selection and risk-shifting problems are potentially large

(e.g., for start-ups) (Huyghebaert and Van de Gucht, 2007).

© 2016 John Wiley & Sons, Ltd.

808 Roberto Guida and Valentina Sabato