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Banking Relationships and Conflicts of Interest
Wook Sohn
KDI School of Public Policy and ManagementMBA ProgramSeoul, Korea
FDIC/JFSR Conference
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).
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
Event Description
Borrowing firms
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.
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
Event Description
Borrowing firms
Estimation of CARs
CARs Mean Median [pos./neg.]
(-7,-2) -5.79** (-2.48)
-4.39 [37/81]***
(-1,+1) -4.85** (-2.94)
-7.85 [32/86]***
(+2,+5) -8.81*** (-4.62)
-8.31 [24/94]***
(-7,+5) -19.45*** (-5.65)
-20.56 [22/96]***
(+6,+51) 22.39*** (3.46)
27.09 [74/44]***
(-1,+51) 8.73 (1.26)
10.92 [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
Event Description
Borrowing firms
CARs for subsample
Prior Relationship
CARs 0 (Type N)
(0,1)(mixed type)
1 (Type P)
t test
N 45 28 45
(-1,+1) -5.62 -7.10 -2.68 1.61
(-1,+51) 13.26 11.29 2.62 -1.28
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) CAR(-1,+51)
Prior RelationshipPrior Relationship* Loan FinanceLocational AdvantageMain Creditor BankLog_AgeLog_SizeSales GrowthProfit/InterestBond FinanceEquity FinanceChaebol#Closed/#Lending Banks Loan_Closed/Loan_AllCollateralized LoanBank 1Bank 2Bank 3Bank 4Intercept
-0.174**(-2.012)
0.196(1.513)-0.012(-0.084)
0.249(1.629)-0.014(-0.142)-0.154(-1.081)
0.007(0.333)-0.566**(-2.155)
-2.261***(-4.862)-0.161(-1.593)-0.136(-0.213)-0.193(-0.604)
0.034(0.429)0.067(0.851)
-0.176*(-1.684)0.009(0.088)
-0.140(-1.431)0.527(0.559)
0.436*(1.719)-1.147***(-2.697)
0.176(1.498)0.026(0.176)
0.262*(1.828)0.007(0.080)
-0.145(-1.141)0.014(0.753)
-0.940***(-3.300)-2.639***(-5.441)
-0.147(-1.537)-0.140(-0.240)-0.160(-0.540)
0.020(0.286)0.074(1.042)
-0.208**(-2.050)-0.023(-0.221)-0.136(-1.416)
0.552(0.715)
F test 3.580*** 3.820***
R-square 0.333 0.368
OLS regressions of CAR (-1,+51)
Three firm ownership variables are included in the regressions.
Probit regressions of the selection equation
[1] [2] [3]
Prior Relationship Market/Book ValuePrior Relationship*Market/Book ValueLocational AdvantageMain Creditor BankLog_AgeLog_SizeSales GrowthBond FinanceEquity FinanceChaebolLoan_Closed/Loan_AllCollateralized LoanBank 1Bank 2Bank 3Bank 4Intercept
2.312***(4.350)1.502**(1.966)
-4.929***(-3.325)
-0.372 (-1.276)
2.307***(3.692)1.925*(1.937)
-4.599**(-2.365)0.851*(1.811)
-0.221 (-0.437)0.091 (0.122)0.354 (0.948)0.300 (0.549)
-0.177 (-0.200)-2.994*(-1.674)-0.037 (-0.095)4.101*(1.909)
-0.071 (-0.273)
-3.562(-1.010)
2.719***(4.007)2.056*(1.919)
-5.257**(-2.456)0.882*(1.747)
-0.174 (-0.297)-0.124 (-0.160)
0.525 (1.174)-0.040 (-0.071)
0.277 (0.295)-2.650 (-1.397)-0.140 (-0.310)3.452*(1.676)
-0.243 (-0.839)0.508 (1.366)0.348 (0.893)
-0.370 (-1.145)0.082 (0.209)
-5.688 (-1.439)
Chi-square 20.850*** 25.030** 47.810***
Pseudo R-square 0.167 0.277 0.343
Three firm ownership variables are included in the regressions.
Heckman estimation of CAR(-1,+51) for the subsample
[1] [2] Full sample
Prior RelationshipPrior Relationship* Loan FinanceLocational AdvantageMain Creditor BankLog_AgeLog_SizeSales GrowthProfit/InterestBond FinanceEquity FinanceChaebol Bank 1Bank 2Bank 3Bank 4Inverse Mills ratioIntercept
0.545*(1.729)-1.073**(-1.966)
0.200 (1.241)-0.023 (-0.118)
0.330 (1.276)-0.130 (-1.325)
0.037 (0.201)-0.047 (-0.894)
-0.774*(-1.874)-3.023***(-4.255)
-0.158 (-1.362)
0.308 (0.687)1.336 (1.465)
0.513*(1.673)-0.933*(-1.674)
0.283*(1.816)-0.025 (-0.125)
0.365 (1.543)-0.093 (-0.929)
0.010 (0.058)-0.044 (-0.809)
-0.788*(-1.891)-2.941***(-4.268)
-0.131 (-1.229)0.111 (1.217)
-0.148 (-1.308)0.059 (0.497)
-0.141 (-1.121)0.554 (1.128)0.820 (0.948)
0.486**(2.104)-1.237***(-3.095)
0.156 (1.430)0.025 (0.172)
0.255*(1.853)0.015 (0.188)
-0.129 (-1.099)0.014 (0.781)
-0.973***(-3.516)-2.653***(-5.870)
-0.144 (-1.551)0.069 (1.038)
-0.217**(-2.283)-0.043 (-0.485)-0.143 (-1.573)
0.483 (0.695)
F test 2.880*** 3.060***0.385
4.670***
R-square 0.326 0.371
No. of firms 82 82 118
Main Results of Part 1Overall 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.
Overview of Theory in Part 2
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: Summary
Ex ante bank reputation h1
Equil. strategy for Type P (Type N)
Market valuation to loan renewal to Type P at t=1
Market valuation to loan renewal to Type N at t=1
High Renew good firm
(Screen)
.)( 1 kLhV
.)( 1 kLhV
Intermediate Mixed strategy:
Renew good firm
with a prob.
(Screen with a prob.)
.)1)(1(
)()(
21
1 De
kLhhV
c
kLehhV
4
)()(
21
1
.
Low Renew bad firm
(Not screen)
0)( 1 hV
kLh
hV2
1)( 1
1
.
Loan Announcement Effects
0
0.5
1
1.5
2
2.5
Direction of increase in D Direction of increase in c
Value of Type P firmsValue of Type N firms
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.
Random effect panel regressions of changes in loan size for the subsample
[1] [2] [3]
Prior Relationship -0.022***
(-4.291)
-0.015***
(-2.818)
-0.015***
(-2.889)
Log_Loan_All
-0.122***
(-9.124)
Prior Relationship*
Log_Loan_All
0.126***
(6.370)
Collateralized Loan_Acquiring
-0.001
(-0.542)
-0.001
(-0.546)
Collateralized Loan_Closed
0.005*
(1.697)
0.005**
(2.013)
Constant -0.017
(-0.290)
-0.099*
(-1.760)
-0.094
(-1.547)
Wald (chi2) 114.97*** 43.09*** 365.82***
Log-likelihood 661.74 602.91 606.27
All other control variables are included in the regressions.
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.
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.
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.