Banking Relationships and the Effect of Monitoring on Loan Pricing

Abstract In a sample of bank loans to small firms we find a positive relation between the bank's monitoring effort and the loan's interest rate. We also observe an inverse relation between the closeness of banking relationships and interest rates. Further, we see that banks less frequently monitor firms with whom they have closer relationships. We conclude that banking relationships are valuable because firms can significantly reduce their costs of capital by establishing and maintaining close ties to a particular bank. As firms successfully complete loan transactions with banks, banks monitor them less frequently and, ultimately, charge them lower interest rates.