Week 6

• don’t need to disclose private information to the entire market —> only 1 party knows your private information (your bank) -> bank loans not traded

• easier to renegoiate with a loan than with a bond -> can be done on a one-to-one basis -> more flexible

• allows young, risky entrepreneurial firms to seek financing —> banks may make some losses now but can recoup later

• easier approval

• less colleteral requirements

• monitoring by bank can reduce agency problems in the borrower and thus, act as a corporate governance mechanisms (Nini, Smith & Sufi, Rev Fin Stud 2012)

1) Hold-up problem

• banks overcharge a “trapped” borrower

• borrowers are trapped when the advantages of relationship lending becomes too big to let it go

2) Soft-budget constraint

• when borrowers are in borderline default, banks lend more to prevent liquidation

• borrowers are aware of this and take less effort to prevent bad outcome

• relationship lending allows efficient allocation of funds —> it does add value

• however, in recent years the value-adding part of relationship lending is eroding

• the paper asks: What happens to borrower’s capital spending and investment activities after their lenders (i.e. Lehman, Bear Stearns & Merrill Lynch) went bankrupt?

• Focus on bankruptcy event of Lehman Brothers and the near death event of Bear Sterns and Merrill Lynch

Findings:

• US firms that have a troubled bank as a lead lender of a capital issue in the 3 years prior to September 2008 experience a 6.3% reduction in investment spending and 12.4% reduction in financing relative to unaffected firms

Why?

• these borrowers have to start all over again with a new bank

  • relationship lending is reset to zero

  • Tougher lending standards and more expensive loans

Implication:

• Only know you love her when you let her go :)

This paper asks:

• how does banking lending friction affect employment outcomes?

Sample:

• 2,000 nonfinancial US firms between 2008-2009

• First step: Borrowers that had pre-crisis relationships with less healthy banks are

  (1) less able to obtain a loan

  (2) pay a higher interest rate

—> this effect is detected even among the largest corporate borrowers

• Second step: these borrowers are forced to lay off workers

Bank credit has real effects on corporate borrowers!

The paper asks:

• whether and to what extend are firms able to compensate for the shortage in loan supply by switching banks and by using other types of financing?

Two-step results:

1) “Bad-banks” cut their lending at the onset of the financial crisis

2) Firms that borrow from these banks reduced borrowing, forced to cut their investment and lyoff their empoyees

Findings:

• Relative to locally-funded banks, foreign banks and domestic banks that rely on international funding cut their lending more aggressively during the crisis

• Affected borrowers will experience a drop in their

  i) asset based

  ii) operating revenue

  iii) ROA

  iv) short-term funding

Takeaway:

• Shock abroad, pain at home (financial globalization has intensified the international transmission of financial shocks with substantial real consequences)

Overall takeaway:

• Do love your bankers. You will miss them when they are gone

• Banks are supposed to monitor borrowers to ensure borrowers repay loans

The paper asks:

• do creditors take action when borrowers misbehave, such as when they violate their convenant requirements?

YES —> creditors take action when borrowers misbehave

Following financial convenants, violated firms sharply reduce their:

• Acquisitiveness; Capital expenditures; Leverage

• Shareholder payouts

And increase:

• Rate at which CEO is being fired

• Operating performance

• Stock performance

Following convenant violations, banks also force borrowers to:

• Layoff their unproductive workers

• Cut their unproductive operating units

• Appoint more outside directors to the board to improve its internal monitoring

• Improve its innovation capacity

Bottom line:

• banks take action when borrowers misbehave

• bank intervention is an important governance mechansim that improves borrower’s performance

The paper asks:

1) whether banks monitor firms’ mergers and acquisitions to the extent that will benefit acquirer’s shareholder?

Answer:

No

• Banks don’t care

• having a bank loan doesn’t allow borrowers to make better M&A deals

BUT, after Bank of America realises Unilever is trying to make a larger capital investment:

• Unilever receives much harsher borrowing conditions: more expensive loan prices, shorter maturity, higher colleteral requirements and more convenant restricitons

Combined takeaways:

• Banks don’t monitor to help borrowers make better strategic decisions

• Banks only monitor when their benefits are potentially hurt such as when borrowers misbehave

• Banks are selfish!

Quesion:

• Given the benefits of bank financing, do corporate borrowers actively manage their chance of obtaining credits?

Findings:

• YES!

• corporate borrowers go out of their way to “buy” access to bank finance

• firms acquire companies in areas that have better access to banks just to increase their ability to borrow more

• Firms go out of their way to buy access to bank financing

1) Debt issuance is the most popular financing option

2) firms can either borrow from a bank or issue a bond; but bank borrowing is much more popular

3) Banks: supply credits & monitor borrowers

-> borrowers go out of their way to improve access to bank credit

1)

• Operating activities

• Investing activities

• Financing activities

2) firms are also called value generators

1) Debtholders & Shareholders

2) trading value

• people respond creatively to opportunities presented by environment

• want to loosen constraints that prevent them from doing what they wish

• humans not only care about money but about almost everything (e.g. respect, honour, power, love, welfare of others)

  —> firms run by humans

  —> if we want to understand firms, we need to understand human nature

• Agents (e.g. manager) vs principals (e.g. shareholders)

• Incomplete contract between managers and shareholders —> managers hold significant residual control right (Shleifer and Vishny, 1997)

• agency porblems arise from divergent interests between managers and shareholders and can be mitigated by monitoring

• helps explain many coporate finance phenomena

• Coase (1937)

• Jensen and Meckling (1976)

• Fama and Jensen (1983)

• one party has private access to informaton which is not available to others

• the presence of information asymmetry between buyers and sellers leads to degraded quality of goods traded in a market (Akerlof, 1970)

sellers: well informed

buyers: less informed

• if you are a buyer & you are going to buy

  1) a used car &

  2) you don’t know anything about cars

  —> it is in your best interst to assume any used care to have low-quality

Market consequences:

• sellers with high-quality used cars wouldn’t want to sell their cars

• Bad drives out good

• Sellers with high-quality cars need to signal the quality of their cars to potential buyers

1) signaling = method by which more informed individuals pass information to the less informed one

• introduced by Spence (1973)

2) the seller needs to advertise the car’s benefits (e.g., energy consumption, emissions, fuel usage etc.)

• information asymmetry and signaling are at the heart of many corporate finance issues

  e.g., Information asymmetry between the firm & its potential external funders

1) Funders’ perspective: Will firm use my money wisely? Will it be able to pay me back? Why is does firm want to issue shares now - is it being overvalued?

—> to be safe, let’s charge them expensively!

2) Firm’s perspective: Better not borrow externally. Should just use own pocket money. Not enough money?

—> Let’s just forego the project

• Shareholders: Does the CEO work hard enough? Why is she using my money to invest in that risky R&D project

• CEO: Let’s not do anything too innovative or “crazy”. Let’s try to “tick the box” to make shareholders happy

  —> palying safe, lack of innovation etc.

1) Internal Funds

• Profits

2) External capital

• Equity

• Debt (tax deductable + gives investors fixed claim)

  • Bank loan

  • Bond

  • Structures Debt securities

1) Internal financing by far the most dominant financing choice

• no interest payments

• more flexible

• easy to get

2) Debt issuance is the most popular external financing choice

—> becomes increasingly more popular in recent years

i) characterized by on-going relationship between bank and borrower

ii) bilateral loan/ sole lender (= only one bank involved) vs. syndicated loan (= more banks involved; one leading bank which has highest proportion)

iii) borrowers need to meet a host of convenant requirements

(= Kreditnehmer müssen eine Reihe von praktischen Anforderungen erfüllen)

iv) customized contracts, not to be traded

i) Credit rating expected

ii) no relationship with borrower

iii) can be traded, many investors

in 1980:

• median firm has 79% of their total debt as bank debt

• this figure increases to 88% for the median firm in 1993

US public firms in 2018:

• only 23% have long-term credit rating and thus, are eligible to seek market-based finance such as Bond

  —> 77% has no choice but borrowing from banks

• only 14% (out of this 23%) actually seeks market-based debt such as bonds

—> bank borrowing is even more importnat in bank-based economies such as China and Germany

• bank loans characterized by “relationship banking”

  i) bank invests in obtaining private information about the borrower

  • bank provides screening (Allen, 1990)

  • bank frequently monitors the borrowers (Diamond, 1984)

  ii) bank has “multiple interactions” with their borrowers

• “relationships” are not restricted to commercial banking

  —> investment banking, private equity and venture capital all involve relationships