This paper brings together two seemingly unrelated branches of the literature
that focuses on different aspects of a bank's interaction with its borrowers:
the relative priority of bank debt, and the role of banks as "relationship
lenders". Specifically, we show that bank seniority plays an important role in
encouraging the formation of ongoing bank/firm relationships. Because the bank
is senior, it is more able to reap the benefits from its relationship with the
firm; because the firm has a relationship with a bank, it is more willing to
exert effort, thus reducing the impact of a recession on its prospects. As a
result, the firm's ex ante value is enhanced when the bank's debt is senior to
that of the firm's other creditors.
The intuition behind our model lies in the fact that, when
the firm's prospects deteriorate, the most senior claimant first benefits from
helping the firm improve its quality, and it is in such states that the true
value of relationship lending comes to light. If banks are made junior to other
creditors, they may benefit little in bad states from additional investment in
the firm, and hence will have little incentive to build relationships that might
allow them to determine the value of such an investment. As a result, making the
bank senior improves its incentives to build a relationship with the firm,
thereby fulfilling an important function of intermediated debt.