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The empirical evidence on various aspects of relationship banking is rather mixed in most cases, a fact which may be attributable partly to the difficulty of defining relationship banking in practice. Nevertheless, it seems that nearly none of the theoretical arguments on the merits and demerits of relationship of relationship banking can be easily refuted on the basis of empirical evidence, though they are not overwhelmingly supported either.

Relationship banking can reduce information asymmetry between a business firm and its creditors, making the relationship bank (and other creditors) willing to give easier access to credit, allowing the firm to mitigate liquidity constraints in its investment activities. Based on this information, relationship banks are often willing to provide insurance functions to their client firms. This can take the form of adjusting the terms of loans according to the cyclical business situation, or giving more intensive care to the client firms in times of financial distress. Here, relationship banks can play a critical role in corporate governance. At the first sign of serious deterioration in the performance in a client firm, the relationship bank begins to intervene in corporate management, typically sending a banker to the board of the firm to help better handle the problems of financial distress. Depending on the severity of the situation, the banker may devise a corporate restructuring plan and direct its implementation. This contingent corporate governance may indeed provide a flexible, informal alternative to the roles played by the market for corporate control or bankruptcy proceedings.

The empirical evidence also seems to demonstrate the risks of relationship banking. Creditor banks tend to discourage risk-taking by client firms, and this may constrain the full realization of corporate growth potential. Also, a firm may be informationally captured by its relationship bank, making it difficult to turn to other financial sources and forcing the firm to pay monopoly rents to the bank. When a relationship bank is also a shareholder of a financially distressed firm, it may influence corporate decisions in its interest, making other creditors less willing to provide additional credit due to potential conflicts of interest. As the result, the net effect on corporate efficiency is ambiguous, not only theoretically but empirically as well.

Furthermore, the roles of relationship banks seem to be best played under certain financial market conditions faced by corporate clients. For instance, when the capital market is deregulated, giving firms easier access to cheap capital, relationship banks may lose their grip on the firms and little monitoring will be undertaken. Also, in the presence of asset price bubbles, relationship banks may neglect their monitoring or insurance functions, and may not be able to fulfill their implicit obligations in the face of massive corporate defaults or a financial crisis. As the corporate financing environment changes, the client base of banks also changes. At such times, banks tend to be strained in their monitoring activity, since they have to keep monitoring inactive clients (for existing loans or guarantees) in addition to intensifying relation-specific investments with new clients.30

Bank-based corporate governance is certainly an option for Asian economies. The capital market-based Anglo-American model requires many institutions to support the system: legal, accounting, auditing, credit rating, investment consulting, investment banking, disclosure and other fair trade rules, internal corporate governance mechanisms, and a market for corporate control, to name just a few. It would take much time and effort to build these institutions, and there is no assurance that this model would work, as is well attested by the series of accounting misdeeds resulting in meltdown of Enron, WorldCom and other large corporations. While the above institutions are also necessary for any form of corporate governance, the market-based model requires a much stronger institutional base. Thus, Asian countries may be advised to make the best use of banks for corporate governance, along with efforts to strengthen relevant capital market institutions. High corporate dependence on bank borrowings in most Asian economies also puts banks in an ideal position to play a role in corporate governance.

A critical constraint in this role for Asian banks is poor corporate governance of the banks themselves. When banks are controlled by the government, frequent interference by bureaucrats or politicians limits the scope for relationship banking. In the case of banks that are owned and controlled by family-based business groups, relationship banking is likely to be geared toward maximizing family interests. Corporate governance in widely-held banks also tends to be very poor due to the characteristics of the banking industry: takeover threats are usually absent; the market is typically oligopolistic with limited competition; and banks suffer from moral hazard due to the expectation of government rescue. Many banks are newly in the hands of the government in the crisis-hit Asian countries. One challenge involves how to strengthen corporate governance in these government banks and what ownership and governance structures should be introduced when they are privatized in the future.

Deregulation and increased competition in the financial markets is often considered a threat to relationship banking. However, once relationship banking has become firmly established between a bank and its corporate clients, the relationship is likely to be maintained, since the bank’s informational advantages can be kept with modest additional effort. In situations where competition is mainly in the capital market, relationship banking might be even more valued, particularly for small and mediumsized firms and young firms without adequate access to venture capital. More importantly, with the transition to a universal banking system, relationship banks can continue to make use of the informational advantages about their clients in the securities business, even though they may no longer rely on bank loans. A universal banking system requires strengthened prudential regulation to deal with the increasing scope for banks’ abuse of conflicts of interest. The challenge is substantially larger if the banks are controlled by family-based conglomerates.

Relationship banking comes under stress when the client firms or banks are in financial distress. In order to better help a client firm in financial difficulty, the relationship bank may need to intervene in corporate management by dispatching a banker to the corporate board of directors. The banker faces a conflict of interest, having a fiduciary duty to both the owners of the firm as well as the bank. This conflict and the possibility of consequent liability for losses by other stakeholders may constrain the bank’s much-needed corporate governance role. To deal with this problem, an efficient mechanism for coordination among creditors is needed. Relationship banking may be a curse when the bank cannot fulfill its implicit obligations due to its own financial problems. Firms are likely to have difficulty turning to other banks or investors because of the informational monopoly by the bank. Moreover, if the bank goes bankrupt, its information capital accumulated through relation-specific investment is mostly lost. Since this represents a loss to the economy beyond the bank’s book value, care needs to be given to the restructuring of banks so that this information capital can be saved to the extent possible.

The questionnaire survey conducted among the officers of large Korean banks shows that monitoring and relationship banking have been substantially furthered by reduced moral hazard on the part of banks and large businesses as well as the accumulation of better information following the crisis. At the same time, it indicates that relationship banking is not yet firmly established in these banks, which is not surprising given that it has been just few years since they were placed under the new business environment in the wake of the crisis. The respondents in the sample banks in which the government has an exclusive or de facto majority share, following the injection of public funds, believe that their banks are critically constrained by the government ownership and political or bureaucratic interference in banking operations. They are also well aware of the potential problems of ownership and control by chaebols as well as those of diffusely-held banks. It will be a great challenge to divest the government ownership of these banks as soon as possible while ensuring sound governance in the privatized banks.

The views expressed in this paper are the views of the author/s and do not necessarily reflect the views or policies of the Asian Development Bank Institute nor the Asian Development Bank. Names of countries or economies mentioned are chosen by the author/s, in the exercise of his/her/their academic freedom, and the Institute is in no way responsible for such usage.

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