Relationship banking and escalating commitments to bad loans Eugene Kang • Asghar Zardkoohi • Ramona L. Paetzold • Donald Fraser Accepted: 22 October 2011 / Published online: 12 November 2011 Ó Springer Science+Business Media, LLC. 2011 Abstract The relationship banking literature sug- gests that business relationships play an important role in the loan decisions of small banks. We test one aspect of this hypothesis using a cross-sectional panel dataset of small banks located in Texas from 1994 to 2002. Our results suggest that small banks located in smaller counties escalate their commitment to bad loans when compared with those located in larger counties, even after controlling for psychological and social factors that influence escalation tendencies. These results highlight the need for small banks to trade-off the positive benefits of adopting a relation- ship banking strategy against its unintended negative consequence. We provide some suggestions on how small banks may lessen their escalation tendencies despite adopting a relationship banking strategy. The results of this study also suggest that small and medium-sized enterprises (SMEs) that develop strong relational bonds with small banks may benefit from continued access to credit facilities, especially during periods when they experience financial distress. Keywords Relationship banking Á Escalation of commitment Á Rural sociology Á County population JEL Classifications C33 Á D82 Á G21 Á M10 Á L26 1 Introduction Relational exchange arrangements play an important role in governing and influencing the outcome of inter- firm transactions (Lado et al. 2008; Zaheer and Venkatraman 1995; Poppo and Zenger 2002; Reddy and Czepiel 1999). Not surprisingly, relationship banking, a form of relational exchange arrangement in the banking industry, has generated much interest among scholars. Relationship banking is a type of financial servicing strategy where banks, particularly small banks, develop relationships with customers through multiple interactions over time and/or across products (Petersen and Rajan 1995; Boot 2000; Elyasiani and Goldberg 2004). While early research E. Kang (&) Division of Strategy, Management & Organization, Nanyang Business School, Nanyang Technological University, Nanyang Avenue, Singapore 639798, Singapore e-mail: aslkang@ntu.edu.sg A. Zardkoohi Á R. L. Paetzold Department of Management, Texas A&M University, College Station, TX 77843-4221, USA A. Zardkoohi e-mail: Zardkoohi@tamu.edu R. L. Paetzold e-mail: rpaetzold@mays.tamu.edu D. Fraser Department of Finance, Texas A&M University, College Station, TX 77843-4218, USA e-mail: D-Fraser@tamu.edu 123 Small Bus Econ (2013) 40:899–910 DOI 10.1007/s11187-011-9392-x