This article has been reviewed according to Science X's editorial process and policies. Editors have highlighted the following attributes while ensuring the content's credibility: How do you measure the value of a relationship? One way is forbearance—what the involved parties would give up to stay together.
That's the principle used by Stephen Karolyi, associate professor of finance at the Costello College of Business at George Mason University, in his co-authored research on relationship lending in the banking industry. "There are many reasons why banks like to use relationship lending, which in practice involves loan officers developing relationships with executives, entrepreneurs and other borrowers," Karolyi says. "An alternative would be arm's-length lending, where each transaction carries its own narrow cost-benefit analysis, without consideration for other services that are being provided or could be provided in the future." Prior research has found that investing in long-term relationships helps lenders gather information on borrowers, which they can use to cross-sell and reduce uncertainty.
But just how much that information might be worth to lenders has been a scholarly blind spot. To address this gap, Karolyi identified a moment when lender forbearance becomes a primary issue. When borrowers end up breaching contractual terms—for example, by exceeding mandated debt-to-earnings ratios or falling below profitability thresholds—lenders can choose to extend leniency or crack down by imposing fees or renegotiating the loan.
When lenders choose the latter, breaching borrowers often take steps to reduce default risk—an additional benefit lenders receive for nonforbearance. "The lender has the upper hand in this negotiation because the alternative outcome is that the loan is recalled," Karolyi says. His paper published in the Journal of Financial Intermediation closely examines how lenders weigh the benefits of covenant breach enforcement against its chief drawback—which is that it might alienate the borrower, thus severing the relationship.
The paper was co-authored by Andrew Bird of Chapman University, Michael Hertzel of Arizona State University, and Thomas G. The researchers assembled a data set comprising loan packages initiated between 1990 and 2016. They cross-referenced contractual terms with financial data for the borrowers to calculate "covenant slack"—a quarter-by-quarter measurement of the likelihood that a given borrower was in breach.
They also quantified changes in the cost of default for borrowers found to be in breach, as well as the probability that those borrowers would switch to a different lender for their next loan. Additionally, the research team mined borrower 8-K filings to collect data on enforcement actions, or actual fees imposed by lenders. A key aspect of the methodology was comparing outcomes for borrowers who were just barely in breach with those who were very close but not quite over the line.
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