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

Outline Background literature Where our paper fits Methodological details Results Conclusion

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)

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

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)

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)

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)

Outline Background literature Where our paper fits Methodological details Results Conclusion

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

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

Outline Background literature Where our paper fits Methodological details Results Conclusion

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)

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

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

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

Stronger relationship and adverse selection Impact on Illiquidity: Proximity0.860**1.208*** Exclusivity0.374*0.520** Distance –0.216**–0.189* # Banks–0.979**–0.654** 10% increase in Proximity (Exclusivity) increases Illiquidity by 2% (4%)

Stronger relationship and adverse selection (contd.) Impact on Trading Volume: Proximity–0.988***–0.697*** Exclusivity–0.519***–0.440*** Distance0.109***0.095*** # Banks0.617***0.651*** 10% increase in Proximity (Exclusivity) decreases Trading Volume by more than 2% (5%)

Stronger relationship and information asymmetry Impact on Information Asymmetry: Proximity0.105***0.061* Exclusivity0.064*0.052* Distance –0.010**–0.010* # Banks–0.106**–0.069** 10% increase in Proximity (Exclusivity) increases Information Asymmetry by nearly 20% (10%)

Stronger relationship and information asymmetry (contd.) Impact on Trading by Institutional Investors: Proximity–0.028***–0.019* Exclusivity–0.009***–0.011*** Distance0.003*** # Banks0.009**0.011** 10% increase in Proximity (Exclusivity) decreases Trading by Institutional Investors by nearly 2% (3%)

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

Stronger relationship and managers’ risk-taking Impact on Stock Volatility: Proximity–0.382***–0.283** Exclusivity–0.332**–0.263** Distance0.047***0.053*** # Banks0.188**0.231** 10% increase in Proximity (Exclusivity) decreases Stock Volatility by 1% (3%)

Stronger relationship and managers’ risk-taking (contd.) Impact on Cashflow Variation: Proximity–2.002*–2.425** Exclusivity–2.702***–2.783*** Distance0.208**0.267** # Banks1.405***1.864*** 10% increase in Proximity (Exclusivity) decreases Cashflow Variation by 6% (33%)

Stronger relationship and monitoring of managers’ behavior Impact on Managerial Appropriation: Proximity–1.830–0.259 Exclusivity–0.781**–0.624** Distance # Banks0.731***0.657** 10% increase in Exclusivity decreases Managerial Appropriation by more than 7%

Stronger relationship and monitoring of managers’ behavior (contd.) Impact on Trading by Managers: Proximity–1.959*–1.933 Exclusivity–0.650*–0.124 Distance0.144*0.038 # Banks0.643**– % increase in Exclusivity decreases Trading by Managers by more than 12%

Stronger relationship and monitoring of managers’ behavior (contd.) Impact on Expenditure on M&As: Proximity– Exclusivity–0.181**–0.106** Distance –0.002 –0.009 # Banks0.172**0.113*** 10% increase in Exclusivity decreases Expenditure on M&As by 38%

Stronger relationship and monitoring of managers’ behavior (contd.) Impact on CEO Turnover: Proximity Exclusivity0.813***0.742*** Distance–0.193–0.202 # Banks–0.907***–0.830** 10% increase in Exclusivity increases probability of CEO-turnover by more than 7%

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

Stronger relationship and firm value Impact on firm’s Tobin’s Q: Proximity Exclusivity0.480**0.352** Distance0.023–0.039 # Banks–0.357**–0.511*** 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.

Outline Background literature Where our paper fits Methodological details Results Conclusion

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

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