Bank-Firm Relationship: Why Firms Should Jump Ship at the First Sign of Trouble

The 2008 financial crisis revealed how dependent firms are on their banking relationships. Khwaja and Mian (2008) demonstrated that small firms with ex-ante relationships with distressed lenders suffered significantly worse outcomes than those partnered with stable banks. While large corporations could easily secure alternative financing, small businesses bore the brunt of the crisis due to information asymmetry and the "stickiness" of bank-firm relationships. This troubling dynamic suggests that firms, especially smaller ones, should be more proactive in managing their banking partnerships.

The consequences of staying with a troubled bank extend beyond just limited credit access. Gabriel Chodorow (2014) found that firms tied to distressed lenders not only borrowed less but also hired fewer workers, demonstrating how banking shocks ripple through both credit and labor markets. These findings imply that firms have strong incentives to monitor their banks' health and be prepared to switch lenders at the first sign of trouble. Yet many firms, particularly smaller ones, remain passive until it's too late.

I propose that firms should adopt a more strategic approach to banking relationships. When a firm borrows from multiple banks and receives signals about their lender's relative stability such as stress test results, the firm should actively shift its business to the stronger institution. Rational firms would want to preemptively reduce exposure to banks more sensitive to negative shocks even before problems materialize. This defensive maneuver could help insulate the firm from future credit crunches.

My hypothesis suggests that in a dual-banking relationship, firms are more likely to terminate accounts with "bad banks" (those more vulnerable to shocks) when they observe positive signals from alternative lenders. This behavior would represent a form of financial self-preservation, particularly for smaller firms that lack the diversification options of larger corporations. The key insight is that firms shouldn’t wait for a full-blown crisis to act and early warning signs should trigger strategic reallocation of banking relationships.

This theory has important implications for both firms and policymakers. Firms should treat banking relationships as dynamic risk management tools rather than passive arrangements. Meanwhile, regulators should consider how policies affecting bank stability (like capital requirements) indirectly impact employment and business activity through these credit channel effects.