This paper examines how the forced closure of failing banks and the transfer of their loans to surviving banks affect the market value of firms that borrow from the closed banks. Pre-existing relationships between firms and the banks that acquire their loans are detrimental to the positive valuation effects of the event. Banks may have an incentive to favor pre-existing relationships to increase the value of previously extended loans. Therefore, loan renewals to firms with prior relationships do not signal borrower quality to the market, which is aware of the banks’ conflicts of interest. This study highlights the importance of the specific mechanisms employed to replace failed banks without decreasing the value of their client firms.

This paper uses a sample of quarterly observations of insured US commercial banks to examine whether the effect of bank capital on lending differs depending upon the level of bank liquidity. We find that the effect of an increase in bank capital on credit growth, defined as growth rate of net loans and unused commitments, is positively associated with the level of bank liquidity only for large banks and that this positive relationship has been more substantial during the recent financial crisis period. This result suggests that bank capital exerts a significantly positive effect on lending only after large banks retain sufficient liquid assets.