The Impact of a Strong Bank-Firm Relationship on the Borrowing Firm

Commercial banks acquire inside information about the firms they lend to. We study the impact of this informationally privileged position on the borrowing firm using a broad panel of U.S. firms over the 1993–2004 period. We measure the strength of the bank-firm relationship by bank-firm proximity, size of the loan, and the lender's insider potential. We show that a stronger relationship, by inducing better monitoring, improves the borrower's corporate governance. Simultaneously, it makes the bank a potentially more informed agent in the equity market. This information asymmetry increases adverse selection for the other market participants and lowers the firm's stock liquidity. This trade-off between improved corporate governance and greater information asymmetry affects the firm's value. Our results have normative implications for the role of banks in the development of financial markets.