The importance of bank seniority for relationship lending

by Stanley D. Longhofer and João A. C. Santos

Working Papers No 58
November 1998

This paper brings together two seemingly unrelated branches of the literature that focuses on different aspects of a bank's interaction with its borrowers: the relative priority of bank debt, and the role of banks as "relationship lenders". Specifically, we show that bank seniority plays an important role in encouraging the formation of ongoing bank/firm relationships. Because the bank is senior, it is more able to reap the benefits from its relationship with the firm; because the firm has a relationship with a bank, it is more willing to exert effort, thus reducing the impact of a recession on its prospects. As a result, the firm's ex ante value is enhanced when the bank's debt is senior to that of the firm's other creditors.

The intuition behind our model lies in the fact that, when the firm's prospects deteriorate, the most senior claimant first benefits from helping the firm improve its quality, and it is in such states that the true value of relationship lending comes to light. If banks are made junior to other creditors, they may benefit little in bad states from additional investment in the firm, and hence will have little incentive to build relationships that might allow them to determine the value of such an investment. As a result, making the bank senior improves its incentives to build a relationship with the firm, thereby fulfilling an important function of intermediated debt.