A Theory of Conflicts of Interest in Banking Relationships

This paper highlights a dark side of banking relationships by elucidating the conditions under which a pre-existing relationship between a lending bank and a borrower can be detrimental to positive valuation effects of loan announcements. The effect of a pre-existing relationship is more likely to be negative when the pre-existing loans are large and firms' screening costs are low. A theoretical model shows that loan announcement's positive effect on borrowers' value due to the standard information advantage can be more than offset by the bank's conflict of interest when the bank's asset quality reputation is poor, i.e. when the probability of the bank holding a bad loan is large.