Benefits from Lending Relationships in Public Debt Markets: Empirical Evidence from the Commercial Paper Market

Introduction The global financial crisis has brought attention to the money markets with specific discussions related to their primary characteristics: low credit risk and high liquidity. As the first signs of the crisis were felt in the money markets in the summer of 2007, front-page articles in the Wall Street Journal discussed how investors have fled commercial paper for the safety of Treasury bills as the Federal Reserve pumped billions of dollars of additional liquidity in the market. Countrywide Financial Corporation (a large nationwide mortgage lender) was a prime example of the impact of the crisis on the commercial paper market as it drew on its bank lines of credit when it was unable to raise the necessary funds in the commercial paper market. These articles raise the question of how borrowers in the commercial paper market maintain access to credit during liquidity squeezes. Diamond (1989) argues that borrowers develop reputation through repeated successful debt transactions with a bank, which allows them to reduce their loan rate over time. Diamond (1989) spawned a body of empirical literature on the value of lending relationships, with the following being representative examples. Petersen and Rajan (1994) find that an ongoing relationship with a lender increases the amount of debt available to the borrower. Berger and Udell (1995) find that lending relationships reduce the rate charged to the borrower on a line of credit and reduce the need for collateral to support the line. Blackwell and Winters (1997) also find that lending relationships reduce the rate charged on lines of credit and reduce the monitoring efforts of the lender. Lending relationships may benefit lenders, too. Yasuda (2005) finds that bank relationships have positive and significant effects on a firm's underwriter choice, and Bharath et al. (2007) find that relationship lenders' informational advantage allows them to sell more information-sensitive products to its borrowers. Financial intermediaries such as banks do not suffer from lack of motivation to monitor their borrowers (as public debt market participants may) and thus are considered superior information producers and monitors. Diamond (1991) extends Diamond (1989) and argues that borrowers who develop sufficient reputation through successful transactions with a bank can leave the intermediated market and borrow directly in the public debt markets. Diamond (1991) does not discuss whether firms that borrow in the public debt markets can benefit from developing relationships with lenders in these markets. That is, can a borrower in a public debt market increase its access to debt and/or decrease its interest rate on debt by developing direct relationships with lenders? We examine this question by testing for the benefits from direct borrower-lender relationships in the public debt market for commercial paper (CP). We take advantage of a well-defined year-end preferred habitat for liquidity (liquidity squeeze) (see Griffiths and Winters 2005a) in CP to examine whether a direct relationship with a CP purchaser (lender) provides better access to credit. We find that the year-end rate increase from the liquidity squeeze is smaller in magnitude and shorter in duration in directly placed than in dealer-placed CP. The smaller size and shorter duration of the squeeze in the directly placed CP market is consistent with the benefits of relationship lending. That is, borrowers who have direct relationships with their lenders are likely to have access to more debt at lower interest rates than other borrowers during periods of constrained liquidity. Our results may be compared to recent research findings on investment banking relationships for public debt issuers. (1) However, investment banks are not lenders in these studies. We examine the value of borrower-lender relationships in public debt markets and find evidence to support the value of relationships when liquidity is constrained. …