The Bank-Business Relationship

Table of Contents

1. Frontmatter

2. Chapter 1. Overview

   Paola Brighi, Maurizio Mussoni

   Abstract

   Asymmetric information significantly challenges bank lending behaviour by introducing uncertainty about borrowers’ creditworthiness (see Chapter 2), which in turn creates conditions for credit rationing (see Chapter 3). Trust, relational capital and regulation are critical mechanisms to mitigate the adverse effects of asymmetric information. Trust between the bank and the firm reduces perceived risk and facilitates smoother financial transactions, while relational capital, built through long-term interactions, provides banks with valuable proprietary information. As we will see, both trust and relational capital are strictly linked with relationship lending (see Chapter 4). Regulation and supervision by banking authorities can, in many ways, intervene to mitigate the negative effects of moral hazard and adverse selection (see Chapter 5) and help banks manage the ongoing “twin transition” towards digitalization and sustainability (see Chapter 6). Together, these elements enable banks to navigate informational asymmetries more effectively, thereby promoting better credit allocation and fostering economic stability.

3. Chapter 2. Asymmetric Information in Banking

   Paola Brighi, Maurizio Mussoni

   Abstract

   In this chapter, we analyze the information asymmetries in the bank–firm relationship related to the lending function. Information asymmetries may lead to banking market failures, like, for example, credit rationing, in particular during periods of economic downturn. Credit rationing occurs when the demand for credit exceeds supply; i.e., whenever the price of credit is lower than equilibrium. We investigate why banks prefer rationing some of their customers instead of increasing interest rates on loans to bring the market into equilibrium (as suggested by neoclassical price theory). Traditionally, credit rationing represents for firms both a problem of obtaining loans and bearing their costs, and thus, it affects both the trend of loans’ interest rates and the quantity of loans granted and utilized, producing a certain rigidity in both loans’ quantities and prices. In particular, the loan risk premium (i.e., the difference between the loans’ interest rates and the risk-free rate) negatively correlates with market interest rates. The rigidity in interest rates implies that banks prefer not to increase the interest rate beyond a certain threshold to limit the potential risks of adverse selection and moral hazard. Several empirical studies suggest that credit rationing is widespread among start-ups, small and young companies and firms investing in Research and Development (R&D). Furthermore, financial constraints become increasingly important during economic crises like those characterizing the last decade.

4. Chapter 3. Credit Rationing and Financial Constraints

   Paola Brighi, Maurizio Mussoni

   Abstract

   If the financial intermediary is not capable of managing informational asymmetries, a market failure may occur (Akerlof, 1970), and the bank may refuse to finance the customer, giving rise to the so-called credit rationing, which represents a typical adverse selection scenario where poor-quality customers drive out high-quality ones. Consequently, even if there is an excess demand for credit and customers are willing to pay a higher price (interest rate), the bank may opt not to provide financing. This decision is intended to mitigate the credit risk associated with potential deterioration in the customer’s financial situation. We analyze credit rationing models by assuming first the absence and then the existence of informational asymmetries, distinguishing between two types of models: (i) Type I rationing model, where ‘some or all customers receive a quantity of credit lower than desired at the prevailing interest rate’ (Keeton, 1979); and (ii) the more widespread Type II rationing model, where ‘banks deny credit to some customers while granting it to others who are entirely indistinguishable from those rationed’ (Keeton, 1979; Stiglitz and Weiss, 1981).

5. Chapter 4. Relationship Lending, Transaction Lending and Corporate Banking

   Paola Brighi, Maurizio Mussoni

   Abstract

   Problems of informational asymmetries between bank and firm, and any corresponding form of credit rationing, can be managed through different ways, like different forms of signalling (e.g., collaterals, equity cofinancing, etc.) or by relationship lending; i.e., by creating an exclusive relationship with a bank. Relationship lending is the internal way by which the financial system tries to overlap the costs of the asymmetric information between the bank and the borrower (mainly represented by small–medium enterprises and households). To understand potential limitations on the investment choices of small firms due to financial constraints, in this chapter, we analyze how a repeated and continuous relationship between a bank and an enterprise (relationship lending) can alleviate financial constraints and limit the impact of credit rationing on the enterprise’s financial choices. The relationship lending model does not preclude using more standardized and impersonal customer relationships, such as transaction lending, which relies primarily on quantitative and objective information (so-called ‘hard information’). The evolution of corporate banking suggests that the two models do not exclude but rather complement each other in what is referred to in the literature as the corporate banking model. In a scenario where transaction lending mainly develops, relationship lending does not disappear but evolves into a more comprehensive and articulated model characterized by different combinations of hard and soft information.

6. Chapter 5. Financial Risks and the Role of Banking Regulation

   Paola Brighi, Maurizio Mussoni

   Abstract

   Banking regulation helps mitigate the adverse effects of asymmetric information in several key ways, starting with credit-related topics. According to the recent guidelines on Loan Origination and Monitoring (LOM), credit policies should be oriented towards a forward-looking approach to credit management, with a recommendation to assess, as part of credit risk analysis, the current and future ability of the client to fulfil obligations arising from the loan contract. In this view, banks, in their credit assessments, should prioritize a realistic and sustainable estimate of the client’s income and future cash flow rather than history and collateral availability. The regulator’s focus is thus on preventing risks rather than intervening with corrective tools once an anomaly has already developed. The risks are categorized into two major types: traditional risks and new risks. Among the key regulatory measures are the Basel Accords, which standardize processes through Regulatory Pillars. The chapter concludes by focusing on risk prevention methods introduced within this framework.

7. Chapter 6. The Digital and Green Twin Transition: Data Governance and Risk Management

   Paola Brighi, Maurizio Mussoni

   Abstract

   The ongoing ‘twin transition’ towards digitalization and sustainability has deep financial implications for the banking sector and presents both challenges and opportunities, like the need to integrate ESG factors into banking operations, the role of digitalization in enabling this transition, and the potential risks and rewards of embracing these changes. Among the emerging risks, significant attention is dedicated to ESG risks and ICT risks, which are discussed from both regulatory and theoretical perspectives. The digital transformation of banks has also had an impact on credit rationing since advancements in data analytics, machine learning and fintech have improved credit assessment processes and expanded access to credit. Recently, the regulatory landscape has changed with the introduction of RDARR, DORA, MiCA and the AI Act, with the goal of ensuring the stability and integrity of the financial sector in this new age. In this chapter, we will analyze their implications for managing ESG risks and ICT risks.

8. Chapter 7. Conclusions

   Paola Brighi, Maurizio Mussoni

   Abstract

   Multiple interconnected factors—including informational asymmetries, financial constraints, regulatory transformations and technological innovation—have profoundly influenced the evolution of the bank-business relationship. This book has examined the core mechanisms through which banks allocate financial resources, assess credit risk, and adapt to regulatory pressures, ultimately shaping the dynamics of corporate finance and the broader financial system.

9. Backmatter