PUBLIC POLICY PERSPECTIVES ON CORPORATE FINANCE: Agency Paradigm and Financial Crisis

1. PUBLIC POLICY PERSPECTIVES ON CORPORATE FINANCE:Agency Paradigm and Financial Crisis Lemma W. Senbet University of Maryland 2006 NTU International Conference on Finance Taipei, Taiwan December 13-14, 2006

2. Issues of Broad Public Policy • Agency Paradigms in Corporate Finance • The Consequences of Limited Liability • John, Nair, Senbet, 2006 • Optimal Bankruptcy Rules • Sequencing of Financial Systems • Bank-based or market-based • Functionality of financial systems • Optimal Banking Regulation • Role of incentives and market discipline • Political economy • John, Saunders, Senbet, RFS 2000 • Cull, Sorge, Senbet, JMCB 2005

3. Financial Sector Reforms in Emerging Economies • Functional Perspective • Capital Market Development • Privatization • Markets for corporate control • Diversity of ownership and fair pricing • Regionalization of markets (e.g., African stock markets) • Capital mobility and global financial crisis • Corporate finance paradigms and financial crisis

4. Distorted Incentives and Financial Crisis In Emerging Economies: Agency Application *(Based on Amar Gande, Kose John, Lemma Senbet “Bank Incentives, Economic Specialization, and Financial Crisis in Emerging Economies” (2006)

5. Motivation • Root cause of a financial crisis arises from the volatility of economic fundamentals driven by: • the degree of economic specialization, • mode of financing of investment opportunities. • Currency instability and excessive debt are factors that aggravate the root cause. • Corporate finance (micro) paradigm. • Macro explanations of financial crises: For example, - Allen and Gale (2000) - Kodres and Pritsker (2002) - Bris and Koskinen (2002)

6. Main Results • Economic specialization and financial crisis: Probability of a financial crisis increases with the degree of economic specialization. • Economic specialization: whether an economy is specialized in a few products/activities. • Financial crisis: low payoff for all firms – joint failure state

7. Main Results • Limited internal financing. • Role of banks: Bank debt financing (most common source of financing in emerging markets) has two effects on probability of financial crisis: • Financial Access Effect (+): Increase menu of projects financed => Lowers degree of economic specialization => Lowers the probability of financial crisis. • Leverage Effect (-): Induces well-known debt induced risk-shifting => Raises the probability of a financial crisis.

8. Main Results • Examine commonly employed mechanisms to manage financial crisis: Deposit insurance, Loan-guarantees, and Bailouts. We focus on bailouts. • Bailout: repayment of debt obligations of corporate sector to banks in a financial crisis. • Role of bailouts: Do they have the desired effect of lowering financial crisis by increasing financial access effect? • The unintended consequence: • Bank Debt Concentration Effect (-): Increases the degree of economic specialization. • Implications for currency induced financial crisis and contagion.

9. Main Results • Ex ante solution mechanisms: Focused towards prevention than ex post resolution of a crisis. Consists of two tax structures that minimize the probability of a financial crisis for any targeted investment policy: • Bank tax structure: Eliminates bank debt concentration>> changes bank incentives • Corporate tax structure: ameliorates leverage effect >> concavifying the after-tax payoffs • Testable predictions and policy implications

10. Figure 1

11. Model

12. Optimal Investment Policy with Unconstrained Financing • Investment policy {qe} -- invest in risky asset for q ≥ qe and safe asset for q < qe. • Idealized investment policy for a social planner.

13. Economic Specialization and Financial Crisis • Proposition 1: The probability of a financial crisis increases in the degree of economic specialization for any given firm-level investment policies. • Interpretation: Probability of a financial crisis - Increasing in ρ (high value implies economic specialization) - Decreasing in q (low values implies more risky policies)

14. Debt and Financial Crisis (Exogenous ρ) • Proposition 2: The probability of a financial crisis is higher when firms have debt as compared to financing fully with equity, and it is increasing in the debt levels of the firms. • Having debt alone is not sufficient: linkage is dampened for low values of ρ. • Next: Endogenizing ρ -- if external financing entails agency costs, menu of projects financed depends on availability and form of financing.

15. Numerical Example Ic = 1, Hc = 2, Lc = 0.5 => qe = 0.33. F = 0.65 => qF = 0.26; F = 0.80 => qF = 0.09.

16. Economic Specialization in a Multi-firm Economy • ρi is correlation of technology i with the basic technology. • If all positive NPV projects can be financed: • However, not all projects are financed due to limited capital as a result of agency costs (Jensen and Meckling, 1976; Myers, 1977), poor investor protection (LLSV 1997, 1998); economic fragility (Rajan and Zingales, 1998). • If projects are financed only with internal financing: • Next: Role of banks as the most commonly available source of financing.

17. Financial Access Effect, Leverage Effect, and Financial Crisis • Proposition 3: Bank debt financing has two effects on the probability of a financial crisis, (1) the financial access effect, i.e., higher access to outside financing for a larger menu of projects => lowers , (2) the leverage effect (Proposition 2) => raises the probability of financial crisis

18. Bailouts and Bank Debt Concentration • Proposition 4: Bailouts provide incentives for banks to concentrate their loans in the highest sector possible (i.e., ρ→ρmax). • Bailout defined as repayment of debt obligations of corporate sector in a financial crisis.

19. Bailout Induced Financial Crisis • Corollary 1: The probability of a financial crisis is with bailouts is higher than the probability of a financial crisis without bailouts.

20. Solution Mechanisms • Focus on prevention than ex post resolution. • Ex ante mechanisms: Two tax structures • Bank tax structure: eliminates bank debt concentration effect. • Corporate tax structure: ameliorates leverage effect. • Reduces the negative effects of bank financing while retaining the positive effect (i.e., financial access effect).

21. Incentive Alignment and Fair Pricing • Proposition 5: A tax system characterized by a marginal tax rate , tax deductible amount (F+i), where i is as specified in equation (20), leads to value maximizing optimal policies {qie}. A tax system characterized by a tax rate t >= tbc, where tbc is given by equation (24) paid by all banks only when they receive the full promised payment from the corporate sector induces the minimal degree of economic specialization (ρmin).

22. Financial Crisis with Optimal Investment • Corollary 2: Under the solution mechanism proposed in Proposition 5, investment is at the optimal level {qe}, and the resulting probability of a financial crisis is: • If the cost of financial crisis is high at ρ=ρmin and {qe}, the social planner may want to implement a more conservative investment policy {qs}. • This can be implemented by our proposed solutions. • However, it may come at the cost of economic growth and efficiency. This may explain conservative investment policies (low growth) in small specialized economies.

23. Discussion of Results • Efficacy of other solution mechanisms: • Loan guarantees • Deposit insurance • Taxation of short-term debt • Foreign currency debt: Corollary 3. • Implementation issues • Empirical Implications

24. Empirical/Policy Implications • The lower the degree of economic specialization, the less susceptible an economy is to a financial crisis. • Higher the availability of external finance, lower the probability of a financial crisis (provided the leverage effect is contained by a solution such as ours). • Higher the extent of government safety nets, higher is the debt concentration of bank loans and higher the likelihood of a financial crisis. • Our analysis shows government safety nets should be fairly priced and accompanied by commensurate improvements in the incentive structure.

25. Financial Crisis and Economic Specialization (1) (2) (3) (4) Coeff T-stat Coeff T-stat Coeff T-stat Coeff T-stat Constant -0.05 -0.93 -0.11 -2.22c -0.04 -5.76a -0.05 -0.62 Econ Specialization 1.36 8.48a 1.05 6.21a 1.02 5.76a 1.16 3.65a Emerging 0.26 5.87a 0.27 6.13a 0.97 18.67a Year Dummies no no yes yes Country Dummies no no no yes Adjusted R2 0.118 0.178 0.164 0.621 Observations 427 427 427 427

26. Probability of Financial Crisis and Economic Specialization (1) (2) (3) (4) Coeff T-stat Coeff T-stat Coeff T-stat Coeff T-stat Constant -1.69 -6.39a -1.96 -7.19a -6.23 -10.74a -2.26 -2.00c Econ Specialization 4.36 5.21a 3.50 4.23a 3.37 4.01a 9.15 3.13a Emerging 0.79 5.42a 0.86 5.82a 6.32 7.07a Year Dummies no no yes yes Country Dummies no no no yes Psuedo R-squared 0.099 0.153 0.161 0.279 Observations 427 427 427 427

27. Conclusions • Model of economic specialization, mode of financing and financial crisis. • Illustrating how agency problems act as a channel for propagating other shocks, e.g., currency risk. • Role of banks: financial access and leverage effects. • Role of bailouts: bank debt concentration. • Propose ex ante mechanisms based on two tax structures to reduce negative effects of bank financing while retaining the positive effect. • Implications for economic growth and efficiency.