Banking Relationships and Conflicts of Interest Evidence from the Korean Bank Reform Wook Sohn KDI SPPM FESAMES 2009

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. Investigate loan announcement effect in the stock market. A theory of loan announcement effect A direct investigation of banks’ lending decisions

Closed Banks C1 C2 C3 C4 C5 Acquiring Banks A1 A2 A3 A4 A5 Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks The Sample Borrowing firms

Features of the Event Exogenous selection and matching and the involuntary transfer of loans in their entirety. No loan officers (thus private information) 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 % Firms’ pre-existing relationships with the acquiring banks are identified.

Literature Bank loan announcements Bank distress announcements Bank consolidation announcements James (87) Lummer, M (89) Billett, F, G (95 ) Slovin, S, P (93) Yamori, M (99) Bae, K, L (02) Ongena, S, M (02) Djankov, J, K (99) Karceski, O, S (00) Involuntary loan agreement Loan renewal decision Lender’s quality change Consider resolutions (loan transfer) P&A Incorporate prior relationships with acquiring banks

Closed Banks C1 C2 C3 C4 C5 Acquiring Banks A1 A2 A3 A4 A5 Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks Overall Effect Borrowing firms

Estimation of CARs CARs MeanMedian [pos./neg.] (-1,+1)-4.85** (-2.94)-7.85 [32/86]*** (-1,+51)8.73 (1.26) [65/53]*

Closed Banks C1 C2 C3 C4 C5 Acquiring Banks A1 A2 A3 A4 A5 Prior Relationship (Type P) No Prior Relationship (Type N) 16 Other Banks Effect of Pre-existing Relationship Borrowing firms

CARs for subsample Prior Relationship CARs 0 (Type N) 1 (Type P) t test N45 (-1,+1) (-1,+51)

Explanatory Variables Bank-firm relationship Exposure to event Firm-specific characteristics Firm ownership Bank- pair dummy Prior rela- tionship Locational advantage Main creditor bank #Closed banks / #Lending banks Loan_closed / Loan_all banks Collateralized loan_closed banks Age Size (asset) Sales growth Profit / interest Bond finance Equity finance Loan finance Chaebol firm Proportion of largest shareholder Small share- holders Foreign share- holders Bank1 Bank2 Bank3 Bank4 Bank5

CAR(-1,+51) Prior Relationship Prior Relationship* Loan Finance Locational Advantage Main Creditor Bank Log_Age Log_Size Sales Growth Profit/Interest Bond Finance Equity Finance Chaebol #Closed/#Lending Banks Loan_Closed/Loan_All Collateralized Loan Bank 1 Bank 2 Bank 3 Bank 4 Intercept **(-2.012) 0.196(1.513) (-0.084) 0.249(1.629) (-0.142) (-1.081) 0.007(0.333) **(-2.155) ***(-4.862) (-1.593) (-0.213) (-0.604) 0.034(0.429) 0.067(0.851) *(-1.684) 0.009(0.088) (-1.431) 0.527(0.559) 0.436*(1.719) ***(-2.697) 0.176(1.498) 0.026(0.176) 0.262*(1.828) 0.007(0.080) (-1.141) 0.014(0.753) ***(-3.300) ***(-5.441) (-1.537) (-0.240) (-0.540) 0.020(0.286) 0.074(1.042) **(-2.050) (-0.221) (-1.416) 0.552(0.715) F test3.580***3.820*** R-square OLS regressions of CAR (-1,+51) Three firm ownership variables are included in the regressions.

A conflict of interest is central to this result. An acquiring bank that had prior debt claims has private information gained through its lending activities to Type P firms and can make more informed decisions on loan renewals (informational advantage). On the other hand, the bank also has an incentive to misuse the private information. By announcing renewals of loans that the bank privately knows to be potentially bad, the bank can protect its own interest by increasing the value of potentially bad, previously extended loans. Conflicts of Interest

The market is well aware of a bank’s conflict of interest, fully recognizing that a bank can take the excessive risk of renewing loans of bad firms. Accordingly, the market does not place credence in the signals of loan renewals to Type P firms. Consistent with this explanation, the negative effect of the pre-existing relationship increases with the size of the loans of the firms. In contrast, the renewal to Type N firms conveys a clear positive signal to the market. Conflicts of Interest

The analyses so far are implicitly based on the assumption that all sample firms get their loans renewed. However, the interpretation is problematic if more Type N firm’s loans get renewed than Type P firm’s loans, because the higher abnormal returns of Type N firms then should simply come from the higher probability of loan renewals. To examine the possible sample selection (or loan renewal) bias, conduct Heckman two stage regression Probit estimation of a dummy variable, Continuation, indicating whether the firms continued their relationships with the acquiring banks, which is available only as of the end of year. OLS of CAR (1,+51) are conducted on the selected sample firms that continued their relationships with the acquiring banks after the event (Continuation =1). Heckit

Probit regressions of the selection equation [1][2][3] Prior Relationship Market/Book Value Prior Relationship*Market/Book Value Locational Advantage Main Creditor Bank Log_Age Log_Size Sales Growth Bond Finance Equity Finance Chaebol Loan_Closed/Loan_All Collateralized Loan Bank 1 Bank 2 Bank 3 Bank 4 Intercept 2.312***(4.350) 1.502**(1.966) ***(-3.325) (-1.276) 2.307***(3.692) 1.925*(1.937) **(-2.365) 0.851*(1.811) (-0.437) (0.122) (0.948) (0.549) (-0.200) *(-1.674) (-0.095) 4.101*(1.909) (-0.273) (-1.010) 2.719***(4.007) 2.056*(1.919) **(-2.456) 0.882*(1.747) (-0.297) (-0.160) (1.174) (-0.071) (0.295) (-1.397) (-0.310) 3.452*(1.676) (-0.839) (1.366) (0.893) (-1.145) (0.209) (-1.439) Chi-square20.850***25.030**47.810*** Pseudo R-square Three firm ownership variables are included in the regressions.

Heckman estimation of CAR(-1,+51) for the subsample [1][2]Full sample Prior Relationship Prior Relationship* Loan Finance Locational Advantage Main Creditor Bank Log_Age Log_Size Sales Growth Profit/Interest Bond Finance Equity Finance Chaebol Bank 1 Bank 2 Bank 3 Bank 4 Inverse Mills ratio Intercept 0.545*(1.729) **(-1.966) (1.241) (-0.118) (1.276) (-1.325) (0.201) (-0.894) *(-1.874) ***(-4.255) (-1.362) (0.687) (1.465) 0.513*(1.673) *(-1.674) 0.283*(1.816) (-0.125) (1.543) (-0.929) (0.058) (-0.809) *(-1.891) ***(-4.268) (-1.229) (1.217) (-1.308) (0.497) (-1.121) (1.128) (0.948) 0.486**(2.104) ***(-3.095) (1.430) (0.172) 0.255*(1.853) (0.188) (-1.099) (0.781) ***(-3.516) ***(-5.870) (-1.551) (1.038) **(-2.283) (-0.485) (-1.573) (0.695) F test2.880***3.060*** *** R-square No. of firms82 118

Main Results 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.

Further Tests and Discussion Checks for contaminating and firm-specific news Sensitivity tests – Control for industry – Control for firm’s credit rating – Different estimation windows – Market-adjusted returns on buy-and-hold strategy Other aspects – Bank’s incentive to diversify loan portfolio – Advantage of multiple lending relationships – Duration of relationship

Further Support 1: A Theory Market’s valuation of bank’s lending decisions Firms with prior relationships (Type P) whether to renew loans to good firm or bad firm (potentially more informed decisions). investor’s concerns arise from bank’s incentive to renew bad firm. bank’s loan renewal does not signal good borrower quality when bank holds large bad loans Firms with no prior relationships (Type N) whether to invest in costly screen- ing to identify good firm (potentially less informed decisions). investor concerns arise from bank’s incentive not to screen. bank’s loan renewal does signal good borrower quality when the screening costs are low.

Loan Announcement Effects

Further Support 2: Banks’ Lending Decisions 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.

Findings Banks tend to continue relationships with firms that have prior relationships even when their market values are lower. Bank is aggressive in expanding loans to firms that have no prior relationships once the new relationships are continued.

Contributions Investigates in great details the effect of pre-existing relationship between banks and borrowers on market’s reactions to the lending decisions. Sheds light on the dark side of bank-borrower relationships conflicts of interest in a different fashion from that of investment banking activities.

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