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

This paper provides new insights into the nature of relationship lending by analysing the role of collateral and its real effects with respect to workout activities. We use a unique data set based on the credit files of five leading German banks, 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 relationship lending is used. Furthermore, our data set contains information on banks workout activities relating to borrowers facing financial distress. We find no significant correlation between borrower quality and the incidence of collateralization, or the degree thereof. Our results indicate that the use of collateral in loan contracts is mainly driven by aspects of relationship lending and renegotiation risk. Relationship lenders do require more collateral from their debtors than normal lenders for two main reasons. First, collateral locks the borrower into the relationship. Second, it strengthens the bank’s bargaining power in future renegotiations. This interpretation is strongly supported by our analysis of bank behaviour when borrowers face financial distress. We find that workout activities for distressed borrowers are positively related to both the housebank status and the degree of collateralization.