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RFS Advance Access originally published online on March 17, 2007
Review of Financial Studies 2007 20(6):2129-2177; doi:10.1093/rfs/hhm015
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Copyright © The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies.

Relationship Banking, Fragility, and the Asset-Liability Matching Problem

Fenghua Song
Olin School of Business, Washington University in St. Louis

Anjan V. Thakor
Olin School of Business, Washington University in St. Louis

Address correspondence to Anjan V. Thakor, Olin School of Business, Washington University in St. Louis, Campus Box 1133, One Brookings Drive, St. Louis, MO 63130, or e-mail: thakor{at}wustl.edu

JEL: G21, G28, D82, D86


  Abstract

We address a fundamental question in relationship banking: why do banks that make relationship loans finance themselves primarily with core deposits and when would it be optimal to finance such loans with purchased money? We show that not only are relationship loans informationally opaque and illiquid, but they also require the relationship between the bank and the borrower to endure in order for the bank to add value. However, the informational opacity of relationship loans gives rise to endogenous withdrawal risk that makes the bank fragile. Core deposits are an attractive funding source for such loans because the bank provides liquidity services to core depositors and this diminishes the likelihood of premature deposit withdrawal, thereby facilitating the continuity of relationship loans. That is, we show that banks will wish to match the highest value-added liabilities with the highest value-added loans and that doing so simultaneously minimizes the bank's fragility owing to withdrawal risk and maximizes the value the bank adds in relationship lending. We also examine the impact of interbank competition on the bank's asset-liability matching and extract numerous testable predictions.

The helpful comments of Viral Acharya, Arnoud Boot, Chris James, Rafael Repullo, Elu von Thadden, participants at the Banco de Portugal Conference on Financial Fragility and Bank Regulation in Lisbon (June 2005), Robert McDonald (the editor), and an anonymous referee are gratefully acknowledged.


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