Collateral, Default Risk, and Relationship Lending:An Empirical Study on Financial Contracting

This paper provides new insights into the nature of relationship lending by analyzing the role of collateral and itsreal effects with respect to workout activities. We use a unique data set based on credit files of five leading Germanbanks, thus relying on real information used in the process of bank credit decision-making. In particular,risk assessment is derived from bank internal borrower ratings and a new proxy for identifying relationshiplending is used. Furthermore, our data set contains information on banks workout activities relating to borrowersfacing financial distress.We find no significant correlation between borrower quality and the incidence, or the degree of collateralization.Our results indicate that the use of collateral in loan contracts is mainly driven by aspects of relationship lendingand renegotiation. Relationship lenders do require more collateral from their debtors than normal lenders,thereby increasing the borrower's lock-in as well as strengthening the bank’s bargaining power in future renegotiations.This interpretation is strongly supported by our analysis of bank behavior when borrowers face financialdistress. We find that housebanks do more frequently engage in workout activities for distressed borrowers, andthat collateralization increases the probability of a workout....