There is mixed empirical evidence on whether close bank relationships are associated with lower or higher earnings quality of borrowing firms. This paper argues that relationship banking allows borrowing firms to conceal true performance when the borrowing firm is either doing very well or is financially distressed. When the firm is doing well it might not want to attract competitors’ attention. When the firm is financially distressed, earnings management helps reduce or defer costs of financial distress, e.g., due to the violation of financial covenants.

We examine a sample of German private firms that rely on bank financing and are subject to mandatory financial reporting. The firm’s financial condition is proxied by the Z-Score for private firms. We find that the firms’ earnings quality is generally lower with relationship banking. This negative association is stronger with borrowing firms having high and poor Z-scores. However, with moderately performing firms, relationship banking is not negatively related to earnings quality, in some analyses even positively. Hence, our paper is the first one to document an inverse U-shape association between the firm’s financial condition and the relationship bank’s impact on the firm’s earnings quality.

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