Banking relationship, relative leverage and stock returns in Japan

This paper revisits the leverage-return puzzle and examines how bank debts affect returns, considering the dynamic nature and heterogeneity of capital structure. We employ relative leverage, the difference between observed and target leverage, in our analysis, and find that returns are positively related to leverage. Relative leverage, rather than observed leverage, provides great explanatory power for returns. Since bank debts are part of the total leverage, we examine how the relative leverage of bank debts affects returns and find a positive and strong relation between the relative leverage of bank debts and returns. The positive relations can be partly explained in that the relative components negatively predict future asset growth, and contain substantial information about future risk. A close banking relationship reduces the financial distress costs of firms. However, very close ties to banks may allow banks to restrict their client firms' investments and to siphon their profits through interest payments. But, during the 1990s crisis, banks had an incentive to evergreen loans to troubled client firms, and a close banking relationship established through high bank borrowing appears to mitigate financial distress and deter further falls in the share prices of troubled firms.