Bank relationships and their effects on firm performance around the Asian financial crisis: evidence from Taiwan

Financial Management (Financial Management Association), Summer, 2004 by Robert C.W. Fok, Yuan-Chen Chang, Wan-Tuz Lee

We evaluate the impact of bank relationships on firm performance for a sample of Taiwanese firms around the 1997 Asian financial crisis. We find a negative relation between the number of domestic-bank relationships and firm performance, but a positive relation between the number o f foreign-bank relationships and firm performance. Firms explored new relationships with domestic banks and reduced their reliance on foreign banks during the crisis. Lending bank reputation and bank loan ratios are important factors explaining firm performance. Factors that affect banking relationships include borrowing firms' profitability. age, size, and leverage, and the primary lending bank's characteristics.

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Although worldwide financial deregulation and disintermediation have created a new environment for commercial banking, bank financing remains important in emerging markets. Yet, very few studies examine the effect of bank relationships on firm performance in developing countries.

We try to fill this gap by examining bank relationships in one emerging market in Asia. We differentiate the impacts of foreign- and domestic-bank relationships on firm performance, and investigate whether the relation between bank relationships and firm performance changed during a particular financial crisis.

As Claessens, Djankov, and Lang (1998) report, firm financial structures and legal systems in East Asia are very different from those in developed countries. A study on the choices of single- or multiple-bank relationships and the number of bank relationships in Asian markets is warranted.

Studies analyzing the impact of foreign bank entities use mainly bank-level data (Berger, Klapper, and Udell, 2001, Claessens, Demirguc-Kunt, and Huizinga, 2001, and Clarke, Cull, Peria, and Sanchez, 2001). These studies examine the effect of a foreign bank entity on the host country's economy and banking system, and the availability of credit to small businesses. We use firm-level data to analyze the impact of foreign-bank relationships from a different perspective. We also examine whether the impact of foreign-bank relationships on local firm performance changed during the 1997 Asian financial crisis.

We analyze a sample of Taiwanese firms for changes in lending relationships. We find a significant shift in firms' number of bank relationships during the Asian financial crisis. The number of foreign-bank relationships declined, while the number of domestic-bank relationships rose. The bank loans-to-total loan ratio dropped during the crisis, as the proportion of domestic (foreign) bank loans rose (dropped). This finding indicates that firms are more closely related to domestic banks in a time of financial difficulty. Foreign-bank and domestic-bank relationships have different effects on firm performance. Firm performance improves as the number of foreign-bank relationships increases, but worsens as the number of domestic-bank relationships increases.

There is no significant association between the choices of single- or multiple-bank relationships and firm performance, but we find a negative association between firm performance and the percentage of bank loans. Bank reputation exhibits a significant and positive relationship with firm performance, implying that high-quality banks play an effective certification and monitoring role.

The paper is organized as follows. Section I reviews the literature on banking relationships. Section II delineates the difference between domestic- and foreign-bank relationships. Section III describes the model specifications, the variables, and the hypotheses. Section IV describes the data and analyzes empirical results. Section V concludes the paper and discusses the policy implications of our findings.

I. Literature Review

We divide our review into theoretical and empirical work.

A. Firm Value and Banking Relationships

Bank loans can enhance firm performance for several reasons. Fama (1985) argues that bank loans avoid the high information costs incurred in public debt offerings. Yosha (1995) suggests that private debt reduces the risk that information will be revealed to rival firms, and thus keeps disclosure cost low. Reductions in these costs should improve firm performance.

Another advantage of bank loans is their ability to serve a monitoring purpose. The more credit offered by a bank, the greater the degree of monitoring of the borrower. Bank monitoring can mitigate the asset substitution and underinvestment problems, and thereby increase firm value.

Bank loans also allow firms to establish a good reputation, which can reduce a firm's cost of capital or increase the availability of credit. Banks with a more prominent reputation are expected to play a more effective certification role. Sharpe (1990) suggests that bank reputation can reduce the inefficient allocation of capital. Unlike public debt, bank loans provide borrowers with valuable flexibility in loan renegotiation.

Although theories suggest bank loans have a positive impact on firm performance, whether single- or multiple-bank relationships are more desirable remains an open question. The impact of the number of bank relationships depends on firm characteristics. A single-bank relationship has the benefits of: reducing information costs (Diamond, 1984); reducing borrowing costs; and avoiding the broadcast of private information (Padilla and Pagano, 1997). Diamond argues that a single bank is enough to resolve the problem of information asymmetries. Multiple-bank relationships can serve the same function, but at higher costs. In fact, there is less of a free rider problem in the case of a single creditor. A single creditor has a stronger incentive to monitor its borrowers and thus can exert a positive impact on the firm's performance.