Do bank lending relationships always enhance financial distress resolution? The case of Germany

Abstract

This article examines the financial distress resolution benefit of bank lending relationships in a system where because of the lack of access to public debt and equity markets, banks do not face competition as providers of capital. For a sample of German firms, this article finds that companies in financial distress are more likely to be liquidated if they have high amounts of bank debt. Furthermore, companies that are saved show higher potential for financial distress a year prior to bankruptcy. This suggests that certain aspects of value of bank lending relationships are dependent on the financial system in which they occur.

Acknowledgements

I thank Steve Wyatt and Michael Ferguson for helpful comments and discussions. I also thank Tom Arnold, Charlotte Ostergarrd, Heiko Penndorf, Stephanie Rauterkus, the participants of the research workshop at Syracuse University, the participants of the conference on ‘Banking Relationships, Credit Extension, and the Macroeconomy’ in Berlin, Germany, and participants at the Financial Management Association European conference in Siena, Italy, for insightful comments and suggestions. This article is a substantial revision of the article ‘Are Bank Lending Relationships Always Beneficial’ and was presented under that title at the aforementioned conferences. All remaining errors are my own.

Notes

¹See, for example, Houston and James (2001), Diamond (1984), Rajan (1992) and Petersen and Rajan (1994) for the benefits of lending relationships and Hoshi et al. (1991) and Gilson et al. (1990) for the positive effect of bank relationships on debt renegotiations. See Boot (2000) for a comprehensive review of the literature on relationship banking.

²Germany's equity markets are relatively underdeveloped with a total market capitalization of only 7% of gross national product (GNP) (Deutsche Bundesbank, 2001). In 1999, outstanding bonds issued by nonfinancial companies totalled $6 billion compared with outstanding bonds by financial institutions of $1148.6 billion (BIS, 2004).

³Boot and Thakor (2000) find that relationship lending enhances a borrower's project payoffs and increased interbank competition will lead to increased relationship lending, the dominant form of lending in Germany.

⁴Davydenko and Franks (2004) find that in a sample of 321 distressed firms in Germany between 1996 and 2003, 86.9% enter formal bankruptcy procedures.

⁶Unlike banks in the USA, German banks are allowed to own equity in corporations, creating a system of group banks. Gorton and Schmid (2000) find that bank control rights from equity improve firm performance, and Morck and Nakamura (1999) find for a sample of Japanese firms that banks take extra care of group companies. However, in a financial distress situation, the bargaining power shifts to nongroup banks. They are able to block a reorganization plan and send a company into liquidation. They are inclined to do so if the benefits of shareholdings in a competitor exceed the possible loan losses. This is in line with the earlier argument that group banks are looking out for group companies. After all, a bank would be a group bank to the competitor in this case.

⁵It is important to point out that the companies in the sample are not able to file for strategic bankruptcy. The law in place at the time allows only for bankruptcy filing in the case of insolvency and debt overload. Filing based on impending insolvency is not possible. Thus, there is no discretion for the firm in making the decision to file for court composition procedures.

⁷As a caveat, I use Altman's algorithm to calculate the z-scores. His formula is based on US companies, and thus the z-score is not 100% transferable to German companies. However, it provides a general idea of the creditworthiness of the firm.

⁸The German laws do not allow any discretion in the timing of the bankruptcy filing but require filing if the company is insolvent or shows negative net worth. Negative net worth is not a reason for immediate bankruptcy in the USA and would generally be referred to as financial distress. In addition, prior to filing, private negotiations between companies and their lenders are taking place and only if those fail or in the event of a shock to the company will they end up in bankruptcy court.

⁹The small sample size is due to the fact that the number of publicly traded companies in Germany is comparatively small.

¹⁰I thank Mr. Markus Kavermann for his support and help in providing me with the necessary accounting data.

¹¹The approximation formula to Tobin's q was used because it is impossible to calculate replacement values of assets for German companies as described in Lang et al. (1989).

¹²Because of the German reunification, companies were filing for bankruptcy in record numbers, especially in the former East Germany. However, these companies were not incorporated.

¹³All in all four cases fall into this category. If we take these out, 59% of the cases ended in liquidation.

¹⁴It might be interesting to note that of the companies in the final sample, only one changed their line of business completely, whereas all the others are still in the same industry. In addition, two of the liquidated companies were bought by competitors and still exist as subsidiaries of those firms.

¹⁵In fact, there are various industries represented in the sample. Only machine building, construction and food and beverages have more than one company in the sample with three from each industry.

¹⁶Although most of the differences are insignificant, one should note the small sample size and the fact that the sample encompasses almost the entire universe of firms. Thus, statistical significance is not as imperative as it would be with a larger sample.

¹⁷This variable does not proxy for the total number of creditors, but for the proportion of banks among all the company's creditors.

¹⁸It should be pointed out that in this situation, borrowers do not necessarily seek out bank debt, but because of the limited availability of other sources of capital, borrowers default to bank debt.