The relationship banking paradox: No pain no gain versus raison d'être

Relationship banking paradox refers to the case that credit market competition may threaten relationship banking practice, but it may stimulate it as well because of differentiation. Using a mixed model of adverse selection and double moral hazard, this paper shows that for some parameter values, relationship banking arises even when the banks compete à la Bertrand, hence supporting the no pain no gain hypothesis. This is due to multilayer nature of the information asymmetry by double moral hazard where an outside bank that does not have the borrower's proprietary information is unable to exert optimal levels of effort in the continuation game.

► We model relationship banking paradox with both adverse selection and moral hazard. ► Relationship banking arises even when the banks compete à la Bertrand. ► Entry is accommodated if high type borrower is of a sufficiently high proportion. ► Relationship banking survives competition if proportion of good borrower is medium.