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The Bank-Firm Relationship: A trade-off between better governance and greater information asymmetry

The Bank-Firm Relationship: A trade-off between better governance and greater information asymmetry. Nishant Dass, INSEAD (with Massimo Massa) JFI/World Bank Conference 26-27 October, 2006. Outline. Background literature Where our paper fits Methodological details Results Conclusion.

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The Bank-Firm Relationship: A trade-off between better governance and greater information asymmetry

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  1. The Bank-Firm Relationship: A trade-off between better governance and greater information asymmetry Nishant Dass, INSEAD (with Massimo Massa) JFI/World Bank Conference 26-27 October, 2006

  2. Outline • Background literature • Where our paper fits • Methodological details • Results • Conclusion

  3. Traditional literature on banks - I • Prevent opportunistic behavior of the borrower • Diamond (RES 84) • Bolton and Scharfstein (JPE 96) • Holmstrom and Tirole (QJE 97) • Mayer (EER 88) • Fama (JME 85) • Jensen (AER 86)

  4. Traditional literature on banks - I • Monitoring – better governance – signal to the market • James (JFE 87) • Lummer and McConnell (JFE 89) • Bhattacharya and Thakor (JFI 93) • Slovin, Sushka, and Hudson (JIMF 88) • Better governance – evidence of a benefit to the borrowing firm due to bank lending

  5. Traditional literature on banks - II • There’s a “dark side” to relationship-lending • Boot (JFI 00) • Bolton and Scharfstein (JPE 96) • Rajan (JF 92) • Sharpe (JF 90) • Padilla and Pagano (RFS 97) • von Thadden (WP 92)

  6. Traditional literature on banks - II • The information monopoly discussed above affects the firm’s incentives • Rajan (JF 92) • von Thadden (RES 95) • Perotti and von Thadden (WP 00)

  7. Traditional literature on banks - II • Banks can also use their private information in the market • Puri (JFE 96) • Gande, Puri, Saunders, and Walter (RFS 97) • Schenone (JF 04) • Ritter and Zhang (WP 06) • Massa and Rehman (WP 06)

  8. Outline • Background literature • Where our paper fits • Methodological details • Results • Conclusion

  9. What we study in this paper • Our paper looks inside the borrowing firm and weighs these pros and cons of its relationship with the lending banks • With a “stronger” lending relationship, we find evidence for improved governance of the firm as well as a greater informational asymmetry around the firm’s stock • This is the trade-off between better governance and greater asymmetry that we allude to

  10. What we find in this paper • Greater informational asymmetry: • Heightens adverse selection in the market • Adversely affects stock’s liquidity • Better governance due to monitoring: • Mitigates risk-taking • Disciplines manager • Effect on firm-value: • Depends on which effect dominates • Better governance should appreciate firm-value

  11. Outline • Background literature • Where our paper fits • Methodological details • Results • Conclusion

  12. Strength of lending relationship • Proximity – fraction of loan from “close” banks • Exclusivity – Herfindahl of the lending syndicate • Average Distance – average distance from all lenders’ HQs (mean 780 miles, median 590 miles) • Dispersedness – number of banks (mean 10, median 7)

  13. Data • Data construction: • Firms’ historical location: Compustat (’91–’04) • Loan-taking sample: LPC DealScan (’85–’04) • Location of LPC lenders: Call Reports, FDIC, BankScope • Banking market: Summary of Deposits (’93–’04) • Variables constructed using: • CRSP-Compustat, CRSP Daily, 13F filings, I/B/E/S

  14. Econometric methodology • Follow firms through the life of the loan • Panel dataset • Firms choose to take a loan • Correct for this selection bias using Heckman’s λ • Loan strength is endogenous • Instrument with: a) local bank market; b) loan strength in the industry; c) firm’s location; d) firm’s pre-loan characteristics; e) industry characteristics • Controls include: • Pre-loan LHS variable and firm- characteristics

  15. Outline • Background literature • Where our paper fits • Methodological details • Results • Greater Asymmetry • Better Governance • Impact on Firm Value • Conclusion

  16. Stronger relationship and adverse selection • Impact on Illiquidity: • 10% increase in Proximity (Exclusivity) increases Illiquidity by 2% (4%)

  17. Stronger relationship and adverse selection (contd.) • Impact on Trading Volume: • 10% increase in Proximity (Exclusivity) decreases Trading Volume by more than 2% (5%)

  18. Stronger relationship and information asymmetry • Impact on Information Asymmetry: • 10% increase in Proximity (Exclusivity) increases Information Asymmetry by nearly 20% (10%)

  19. Stronger relationship and information asymmetry (contd.) • Impact on Trading by Institutional Investors: • 10% increase in Proximity (Exclusivity) decreases Trading by Institutional Investors by nearly 2% (3%)

  20. Outline • Background literature • Where our paper fits • Methodological details • Results • Greater Asymmetry • Better Governance • Impact on Firm Value • Conclusion

  21. Stronger relationship and managers’ risk-taking • Impact on Stock Volatility: • 10% increase in Proximity (Exclusivity) decreases Stock Volatility by 1% (3%)

  22. Stronger relationship and managers’ risk-taking (contd.) • Impact on Cashflow Variation: • 10% increase in Proximity (Exclusivity) decreases Cashflow Variation by 6% (33%)

  23. Stronger relationship and monitoring of managers’ behavior • Impact on Managerial Appropriation: • 10% increase in Exclusivity decreases Managerial Appropriation by more than 7%

  24. Stronger relationship and monitoring of managers’ behavior (contd.) • Impact on Trading by Managers: • 10% increase in Exclusivity decreases Trading by Managers by more than 12%

  25. Stronger relationship and monitoring of managers’ behavior (contd.) • Impact on Expenditure on M&As: • 10% increase in Exclusivity decreases Expenditure on M&As by 38%

  26. Stronger relationship and monitoring of managers’ behavior (contd.) • Impact on CEO Turnover: • 10% increase in Exclusivity increases probability of CEO-turnover by more than 7%

  27. Outline • Background literature • Where our paper fits • Methodological details • Results • Greater Asymmetry • Better Governance • Impact on Firm Value • Conclusion

  28. Stronger relationship and firm value • Impact on firm’s Tobin’s Q: • 10% increase in Exclusivity increases the firm’s Tobin’s Q by more than 3% • A trading strategy using Exclusivity yields 5–6% p.a.

  29. Outline • Background literature • Where our paper fits • Methodological details • Results • Conclusion

  30. What have we seen • Stronger lending relationship • Reduces liquidity • Increases information asymmetry • Reduces risk-taking • Abates managerial appropriation • Improves overall governance • Seems to enhance firm-value

  31. What do these results mean • Test of the “dark-side” of bank-lending • Analyze the impact of stronger lending relationship on the firm • Evidence of a trade-off • Raises questions about the role of banks in the financial markets, as Glass-Steagall Act is abolished • A step toward a comparison of banks vs. financial markets

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