Banking relationships and conflicts of interest (Korea)

Bank lending decisions provide valuable information about borrowing firms that is not available to the capital markets. This dissertation explores the impact of the bank loan signaling in the wake of a financial crisis, using the data from the Korean bank reform of 1998. The reform resulted in the forced closure of failing banks and transfer of their loans to surviving banks, which was followed by the acquiring banks' own renewal decisions. A commonly held view is that the acquiring banks' lending decisions to firms that had a prior relationship with the banks provide more informative signal because of an information advantage the banks possess.; Surprisingly, the abnormal returns of firms that had a prior relationship with the banks acquiring their loans are significantly lower than those of firms that had no prior relationship, after controlling for various firm and bank characteristics. This result suggests that banks have an incentive to favor firms with a pre-existing banking relationship at the time of loan renewal to increase the value of previously extended loans. Therefore, loan renewal does not necessarily signal borrower quality to the market that is aware of the banks' conflicts of interest.; A theoretical model shows that a positive loan announcement effect on the value of borrowers due to the standard information advantage can be more than offset by the bank's conflict of interest. A pre-existing relationship is more likely to be detrimental to the market's valuation when the size of the pre-existing loans is large. Consistent with this argument, the negative valuation effect of a pre-existing relationship increases with the size of pre-existing loans from the banks with conflicts of interest.; A direct investigation of the banks' lending decisions further supports the banks' conflicts of interest that come with banking relationships. Banks tend to maintain the lending relationships with the borrowing firms that had a pre-existing relationship. However, the loan growth rates of those firms are significantly lower than those of the firms that had no prior relationship but whose relationship established from the loan transfers is retained.