No. 645 - Costs and benefits of creditor concentration: An empirical approach

High concentration of creditors can have two beneficial effects on borrowers: i) by enhancing lenders' ability to monitor, it can reduce the likelihood of financial distress; ii) by reducing coordination failure among creditors, it can help a distressed firm to avoid bankruptcy. However, a strong probability of debt renegotiation can exert a feedback effect on the likelihood of financial distress, by generating perverse ex-ante incentives for borrowers (soft budget constraint). Moreover, high concentration of creditors can expose borrowers to greater liquidity risks. Using Italian data on manufacturing firms, we try to separate empirically these conflicting effects. Our results show that, if we control for the soft-budget-constraint and liquidity effects, high concentration of bank credit reduces the likelihood of financial distress and liquidation, as predicted by the literature on relationship banking. But these benefits do not come without costs: i) enhanced monitoring is offset by the soft-budget-constraint effect and ii) higher concentration of credit lines increases liquidity risks and thus makes both financial distress and liquidation more likely. Ultimately, the overall effect of more concentrated banking relations is a lower probability of liquidation but a higher probability of financial distress. This helps to explain the widespread existence of multiple but asymmetric banking relations in Italy.