Overview on Relationship Banking and Its Role in Corporate Governance

Connection-based banking, which is at the heart of the “crony capitalism” that many blame for the Asian crisis of 1997, is often referred to as relationship banking or relationship-based banking. The financial crisis highlighted the dangers of relationship banking. Relationship banking, on the other hand, provides numerous advantages. First and foremost, it enables banks to maximise their comparative advantages over the public debt market. In a world of incomplete contracts, banks frequently repeat transactions across different financial services, allowing for economies of scale and scope in information production as well as reputation building for both parties, which can be an important factor in loan negotiations or other financial transactions.

Relationship banking can be defined as banking procedures that are geared to enhance these benefits. Second, because of its potential role in corporate governance, we are particularly interested in relationship banking in Asia. Even the largest company groups in Asia are primarily family-owned. Corporate governance has historically been poor due to family owners’ management control.

Family business owners have been vocal in their opposition to the implementation of proper corporate governance processes, which would limit their ability to pursue family interests at the expense of minority shareholders. Minority shareholder expropriation has been a severe concern, as it constitutes a gross misallocation of business resources, as well as being unfair and harmful to capital market development.

Relationship Banking

Relationship banking can be characterised as a financial intermediary’s provision of financial services based on a long-term investment in gathering firm-specific knowledge through many contacts with various financial services (Boot, 2000). Because of the nature of information production, banks have an edge in gathering/producing information about their clients.

First, there are economies of scale: learning via repeated interactions lowers the cost of gathering/producing knowledge.

Second, there may be scope economies: banks can use information gathered on one sort of service to provide other ones (Petersen and Rajan, 1994).

Third, financial contracts are frequently incomplete: through repeated transactions across services, banks and customers can establish commitment and reputation, enabling for low-cost renegotiation of debt obligations (Lehmann and Neuberger, 2001).

Because of this property of information production, relationship-based banking is a logical fit for banks.

Changes in Relationship Banking since the 1980s 

Many people believe that relationship banking has altered since the 1980s, notably in Japan. These shifts have been fueled by two separate sources. The first is financial market liberalisation, notably in corporate bond offerings, and the second is the banking sector’s significant difficulty following the bubble burst in the early 1990s. In some ways, these two forces appear to have worked in tandem, while in others, they appear to have worked in opposite directions. Financial market liberalisation, for example, has damaged the MB relationship, yet the prolonged recession and increasing danger of corporate default has enhanced the importance of the MB relationship for many organisations.

Since the 1980s, the MB system appears to have remained mostly unchanged. In terms of MB financing, shareholding, executive delegation, and debenture-related enterprises, Hirota and Horiuchi (2001) found that MB ties were rather consistent even in the 1990s for the top Japanese firms. Because MB interactions have numerous characteristics, they determined each firm’s MB based on a direct question to the largest Japanese firms.

Corporate Governance in Banks 

The fulfilment of any benefits that can be expected from relationship banking is contingent on the banks’ corporate governance. Otherwise, they will have no motivation to invest in relationships, and relationship banking techniques may merely be a simple way to manipulate bank resource allocation. If banks are directed to lend to specific industries and enterprises (by the government, bureaucracy, or politicians), there is little place for relationship-based banking. The same is true if non-financial corporate groupings own and control banks.

The bank’s controlling shareholders will have a significant incentive to use bank loans and other services to benefit their group or family rather than the bank’s whole shareholder base. Firms who are not subsidiaries of the group or have other close business ties have little motivation to have a tight banking relationship with this bank in this instance. Some of the external corporate governance systems in banking are weaker than in non-financial companies.

For example, restrictions governing the qualification of potential acquirers or the prior approval of the bank regulator limit the market for corporate control for banks. Due to oligopolistic marketplaces for several financial services, product market discipline is also lacking.

Are there differences among banks? 

It’d be interesting to see whether the answers to some of the questions change much between banks. Following the financial crisis, large public funds were injected through the Korea Asset Management Corporation, Korea Deposit Insurance Corporation, and other government institutions, resulting in the government owning a controlling share of the three sample banks. Their business and customer bases are similar to those of the main metropolitan banks, with a heavy focus on multinational corporations.

However, there are some disparities between them in terms of how and how much they restructured after the crisis. The most severe restructuring took place at Hanvit Bank, which was formed by the amalgamation of two major city banks. Its assets fell from 97 trillion won to 72 trillion won in the three years leading up to the end of 2000; branch offices fell from 991 to 625; and the number of workers fell from 17,000 to less than 10,000.

 Korea Exchange Bank undertook a similar level of reform, with a large stakeholder (Commerzbank) from Germany engaging in management. Chohung Bank, on the other hand, has been the least affected of the city banks: during the three years leading up to the end of 2000, there were essentially no changes in the size of its total assets or number of branches, despite a significant fall in its workforce.

Conclusion

Higher danger of corporate default and the banks’ own survival, as well as the improved knowledge base they have created since the start of the financial crisis, appear to be the most crucial motivators for better monitoring and relationship banking. More structural variables, such as client firms’ increasing negotiating power and banks’ ownership of equity interests in their corporate clients, do not appear to have had a significant influence. If the financial situation in the corporate and banking sectors improves, this could signal that banks’ increased efforts for monitoring and relationship banking would be weakened.