Andrew Winton

Corporate Financial Structure, Incentives and Optimal Contracting

The firm can be regarded as consisting of several groups of investors and managers whose interests are regulated by the contracts between them. This survey covers the literature that looks at the nature of optimal financial contracts in the face of various asymmetries of information, control and type. Five areas are considered: (i) costly state verification and agency; (ii) adverse selection; (iii) the allocation of control rights among investors and the design of ownership structure; (iv) the allocation of risk and (v) acquisition of information.

Banking in transition economies: does efficiency require instability?

Efficient banks are essential for capitalist economies, yet bank failures result in costly externalities, leading to a potential conflict between the risk choices of private agents that own banks and socially optimal choices. This conflict is particularly severe in transition economies. Evidence suggests that these economies have banking systems which are both prone to failure and inefficiently small; established banks suffer from an overhang of bad loans, and implicit subsidies often favor continued lending to inefficient state-owned enterprises (SOEs). If a regulator seeks to impose higher capital standards to reduce the odds of bank failure, privately-held banks may instead exit the industry, shrinking a system that is already inefficiently small. If loans to SOEs are subsidized so as to mitigate repercussions from their failure to workers and to banks, established banks may prefer such loans over riskier unsubsidized loans to entrepreneurial firms. Encouraging entry into banking may mitigate this problem, but the new banks will be quite risky and prone to failure. The upshot is that, in transition economies, achieving an efficient banking system is likely to require significant instability.

Chapter 8 Financial intermediation

The savings/investment process in capitalist economies is organized around bank-like financial intermediaries (“banks”), making them a central institution of economic growth. These intermediaries borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why are banks so pervasive? What are their roles? Are banks inherently unstable? Must the government regulate them? In this chapter we survey the last 15 years’ of theoretical and empirical research on these issues We begin with theories and evidence on the uniqueness of banks. Key issues include monitoring or evaluating borrowers, providing liquidity, combining lending and liquidity provision as a commitment mechanism, and the coexistence of banks and markets. We then examine interaction between banks and borrowers in more detail, focusing on the pros and cons of dynamic bank–borrower relationships, the relationship between loan structure and monitoring, and between banking sector structure and monitoring, “credit cycles” and capital constraints, and the role of “non-traditional” bank activities such as equity investment. We then turn to research on banking panics and the stability of the banking system, focusing on the incidence of banking panics internationally and historically, the causes of panics, the role of bank coalitions in forestalling panics, and whether banks are inherently flawed. This leads to questions concerning government regulation of banks. Here, we focus on possible moral hazard problems emanating from deposit insurance and on the roles of bank corporate governance and capital requirements. We conclude with a summary of our current understanding and directions for future research.

Bank Capital, Borrower Power, and Loan Rates

We test the predictions of several recent theories of how bank capital affects the rates that banks charge their borrowers. Consistent with previous studies, higher bank capital has a negative impact on loan rates, and this effect is focused on bank-dependent borrowers. Further investigation shows that borrower cash flow is a critical determinant of this relationship: compared to high-capital banks, low-capital banks charge more for bank-dependent borrowers with low cash flow, but offer greater discounts for bank-dependent borrowers with high cash flow. Our results support the bank-fragility theory, which argues that low bank capital generally toughens bank bargaining power, especially vis-a-vis low-cash-flow borrowers, but weakens bank bargaining power vis-a-vis high-cash-flow borrowers. By contrast, our results are not consistent with models where low-capital banks either consume reputational capital or are generally more risk averse than high-capital banks.

Risk Overhang and Loan Portfolio Decisions: Small Business Loan Supply Before and During the Financial Crisis

We estimate a structural model of bank portfolio lending and find that the typical U.S. community bank reduced its business lending during the global financial crisis. The decline in business credit was driven by increased risk overhang effects (consistent with a reduction in the liquidity of assets held on bank balance sheets) and by reduced loan supply elasticities suggestive of credit rationing (consistent with an increase in lender risk aversion). Nevertheless, we identify a cadre of strategically focused relationship banks that made and maintained higher levels of business loans during the crisis.

Risk Overhang and Loan Portfolio Decisions

Despite operating under substantial regulatory constraints, we find that commercial banks manage their investments largely consistent with the predictions of portfolio choice models with capital market imperfections. Based on 1990-2002 data for small (assets less than

Competition and Corporate Fraud Waves

1 billion) U.S. commercial banks, net new lending to the business, real estate, and consumer sectors increased with expected sector profitability, tended to decrease with the illiquidity of existing (overhanging) loan stocks, and was responsive to correlations in cross-sector returns. Small banks are most appropriate for this study, because they make illiquid loans and manage risk via on-balance sheet (non-hedged) diversification strategies.

Product Market Interactions and Corporate Fraud

Our paper examines the effect of product market competition on firms’ incentives to misreport financial information to investors. We examine three specific channels through which product market competition can affect the information environment in an industry and individual firms’ incentives to misreport information. We show that the lack of product market sensitivity to individual firm information tends to encourage fraud commission. The use of relative performance evaluation (i.e., industry benchmarking) in managerial retention decisions also encourages fraud. The lack of information collection about individual firms tends to decrease the probability of fraud detection and increase the probability of fraud commission. All three channels are more likely to be present in more competitive industries, implying that fraud propensity is on average higher in those industries. We show that fraud can help explain the predictable busts in competitive industries. Post-boom poor performance in competitive industries is largely concentrated in firms that are likely to have committed fraud during the booms. The underlying reason is twofold. First, fraud propensity is more cyclical in more competitive industries. Second, the consequence of fraud in competitive industries is particularly bad following booms. Our results suggest that the dynamic of fraud can amplify the cyclical fluctuations in the real economy, particularly in competitive industries.

Cheating in China: Corporate Fraud and the Roles of Financial Markets

We examine three information channels through which product market interactions in an industry can affect firms’ incentives to misreport financial information to investors. We find that lower product market sensitivity to individual firm’ information and greater use of relative performance evaluation encourage the commission of financial fraud. Less collection of information about individual firms decreases the probability of fraud detection and increases the probability of fraud commission. We also examine dynamic effects of fraud. Our results suggest that, in fragmented industries, fraud can amplify cyclical fluctuations in the real economy.

Soft Collateral, Bank Lending, and the Optimal Credit Rating System

We find that financial misreporting in China is less likely if a firm’s province is more financially developed, if its largest shareholder holds more shares, or if the firm is in a government-supported industry, and more likely if the firm is connected to the market regulator. Many conventional Western governance mechanisms do not affect the incidence of misreporting. Natural experiments using two recent reforms support causal effects of financial development and blockholdings on misreporting. We also find that financial development reduces the frequency of tunneling and insider trading, but ownership structure has differing effects on these two types of fraud.We find that financial misreporting in China is less likely if a firm’s province is more financially developed, if its largest shareholder holds more shares, or if the firm is in a government-supported industry, and more likely if the firm is connected to the market regulator. Many conventional Western governance mechanisms do not affect the incidence of misreporting. Natural experiments using two recent reforms support causal effects of financial development and blockholdings on misreporting. We also find that financial development reduces the frequency of tunneling and insider trading, but ownership structure has differing effects on these two types of fraud.