Does your neighbour know you better? The supportive role of local banks in the financial crisis

Abstract

Abstract Relationship lending allows local banks to collect private information about their customers and to mitigate information asymmetries that often lead to credit rationing. In this paper, we argue that soft information collected through relationship lending favors lending decisions even when borrowers’ quality is poor from a “hard-information” perspective. We compare the behaviour of local versus non-local banks using data immediately before and after the 2007–08 Financial Crisis. We exploit the heterogeneity in banks’ reliance on soft information to study how their lending strategies changed when firms’ hard-information indicators deteriorated after the outbreak of the financial crisis. Our paper shows that firms predominantly funded by local banks reported lower credit rationing immediately after the outbreak of the 2007–08 Financial Crisis. In the same period local banks were also less likely to terminate existing relationships with their customers, suggesting that they continued funding their clients even when borrowers’ balance sheet variables worsened. We rule out alternative hypotheses explaining our results, such as demand effects, “zombie-lending” behaviour, or different impacts the financial crisis had on the credit supply of local versus local firms. This leads us to conclude that thanks to their greater reliance on soft information, local lenders supported their customers to a higher extent during bad times, at least in the period following immediately the outbreak of the financial crisis.