Financial Distress and Bank Lending Relationships

One of the most important risks faced by a bank is that of loan default by its borrowers. Existing literature has documented the negative announcement-period returns for lending banks when a big sovereign borrower announces a moratorium on its bank loans. In contrast, little research has been undertaken that analyzes bank shareholder wealth effects when a major corporate borrower declares default and/or bankruptcy. This paper uses a unique data set of bank loans to examine the wealth effects on lead lending banks when their borrowers’ suffer financial distress. For the 10-year period from 1987 to 1996, we examine a sample of 71 firms that defaulted on their public debt and a sample of 101 firms that filed for bankruptcy. We find a significant negative wealth effect for the shareholders of the lead lending banks on the announcement of bankruptcy and default by the borrowers of their bank. We also find that the banks with relatively higher exposure to the distressed firms have larger negative announcement-period returns, although individual loan details are not public knowledge. Thus, the market appears to discriminate among lenders in a way not inconsistent with a correct inference of individual borrower exposures. We also examine the impact of various loan and bank characteristics on the magnitude of announcement returns. We find that the existence of a past lending relationship with the distressed firm results in larger wealth declines for the bank shareholders. Finally, we find that financial distress also has a significantly negative effect on borrower’s returns.