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Research Questions

Banking Relationships and Conflicts of Interest Wook Sohn KDI School of Public Policy and Management MBA Program Seoul, Korea FDIC/JFSR Conference. Research Questions. Highlight conflicts of interest in banking relationships.

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Research Questions

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  1. Banking Relationships and Conflicts of InterestWook SohnKDI School of Public Policy and ManagementMBA ProgramSeoul, Korea FDIC/JFSR Conference

  2. Research Questions • Highlight conflicts of interest in banking relationships. • Key feature is pre-existing relationships (or financial claims) between banks and borrowers before the banks’ lending decisions. • Approach • Part 1: Loan announcement effect in the stock market. (empirical investigation) • Part 2: Loan announcement effect in the stock market. (theory) • Part 3: Banks’ lending decisions (empirical).

  3. Event Description Borrowing firms Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks

  4. Features of the Event • Exogenous selection and matching and the transfer of loans in their entirety. • No personnel were transferred from the closed banks to the acquiring banks (purchase and assumption). • Distinctions between the closed banks and the acquiring banks. - BIS ratios: 5.32% vs. 9.64% - Non-performing loans: 9.08% vs. 3.01% - Market shares: 6.95% vs. 30.96% • Firms’ pre-existing relationships with the acquiring banks are identified.

  5. Event Description Borrowing firms Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks

  6. Estimation of CARs

  7. Event Description Borrowing firms Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks

  8. CARs for subsample

  9. Explanatory Variables

  10. OLS regressions of CAR (-1,+51) Three firm ownership variables are included in the regressions.

  11. Probit regressions of the selection equation Three firm ownership variables are included in the regressions.

  12. Heckman estimation of CAR(-1,+51) for the subsample

  13. Main Results of Part 1 • Overall effect on firm value in the stock market: positive • Loss of the relationship-specific advantage with the closed banks is outstripped by the gain from good quality of the acquiring banks. • Effect of the pre-existing relationships on the positive valuation: negative • Informational advantage from the pre-existing relationships is more than offset by banks’ incentives to misuse the information. • The larger the size of pre-existing loan, the more negative the effect of pre-existing relationships.

  14. Overview of Theory in Part 2Market’s valuation of bank’s lending decisions

  15. Loan Announcement Effects

  16. Motivation of Part 3 • Firm’s abnormal stock returns to estimate the net gain for the firm may not tell the whole story . • For example, the market’s reactions to the event may be inconsistent with the actual behavior of loan officers of the acquiring banks. • Examine directly how the pre-existing relationships between banks and borrowers affect the banks’ lending decisions. • whether the lending relationship is maintained. • how the size of loans changes.

  17. Random effect panel regressions of changes in loan size for the subsample All other control variables are included in the regressions.

  18. Main Results • Banks tend to continue relationships with firms that have prior relationships even when their market values are lower. • Evidence for conflicts of interest • Bank is aggressive in expanding loans to firms that have no prior relationships once the new relationships are continued. • Value of bank relationship to its client firms decline over time. • Bank quality does not necessarily conveys risk classes of its client firms.

  19. Contributions • Investigates in great detail the effect of pre-existing relationship between banks and borrowers on banks’ lending decisions and market’s reactions to the lending decisions. • Sheds light on the fundamentals of bank-borrower relationships, • especially the dark sides of banking relationships: conflicts of interest.

  20. Policy Implications • Underscores the importance of the specific mechanisms employed to replace failed banks – the liquidation of banks followed by transfers of their loans to better banks can make client firms better off. • Mitigates the policy-maker’s concerns about potential negative effects of banking sector restructuring on the values of sound client firms of failed banks. • Suggests that the intensity of firms’ pre-existing relationships with acquiring banks is important in understanding how successful a bank consolidation is in speeding up the resolution of financially distressed firms.

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