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.