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Universal banking and firm risk-taking
ELSEVIER
Journal
of Banking
and Finance
18 (1994) 307-323
Universal banking and firm risk-taking Kose John*, Salomon Brothers
Teresa
A. John
and Anthony
Saunders
Center, Leonard School of Business, New York University, New York, NY 10012, USA Final version
received December
44 West 4th Street,
1993
Abstract
This paper analyzes the welfare implications of banks taking equity stakes in firms under conditions of imperfect information and moral hazard. Two cases of bank control over investment decisions are analyzed. In the first, the bank does not control the investment decisions of the firm. Here, the investment efficiency is higher and bank risk is lower for an optimal positive level of bank equity holdings. However, in the case when the bank has veto power over investment proposals by the firm, there is a trade off between increased investment efficiency and increased bank risk. Key words: welfare
Universal banking;
JEL class@ation:
Risk-taking;
Commerce; Investment
efficiency; Social
G21, G24, G28
1. Introduction While many observers agree that the structure of the U.S. banking industry is in need of reform, there are wide disagreements over what should be done. One of the major areas of debate is over whether the current separation (and restrictions) between commerce and banking should be relaxed in any future restructured financial system. In the U.S. a number of regulatory reports have considered, either directly or indirectly, the costs and benefits of bank-commerce interlinks. For example, reports issued by Corrigan (1987a,b) were generally opposed to relaxing, the current separation between banking and commerce. On the *Corresponding
author We are grateful to Mitchell Berlin, Loretta Mester, Manju Puri and Anjan Thakor for helpful discussions. Kose John acknowledges research support from a Bank and Financial Analysts Faculty Fellowship, Teresa John from a New York University Summer Research Grant and Anthony Saunders from the John M. Schiff Chair. 0378-4266/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0378-4266(93)EOO63-T
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other hand, the more recently issued Treasury Report (1991) went in the opposite direction advocating the establishment of commercial firm owned financial service holding companies. There is a highly complex set of interrelated costs and benefits to relaxing the separation between banking and commerce (for a discussion of the public policy costs and benefits, see Saunders, 1994). Potential benefits may be grouped into two categories. In the first category we can consider potential sources of value arising from the combined operation of a bank and a commercial firm. For example, if a bank is acquired by a commercial firm (or vice versa) and the depository institution grows in size as well as in the scope of its activities (product mix is larger) its average (unit) costs of producing banking services may decline resulting in economies of scale and/ or economies of scope. In addition to savings on costs, revenue gains may also result from an increased organizational efficiency of the combined firm. Further, product and geographic diversification benefits from the bankcommercial firm conglomerate organization may also generate value gains by reducing the costs of financial distress and contracting. A second category of benefits, from integrating banking and commerce, may come from reducing agency costs and the costs of asymmetric information. For example, if the resulting less restricted takeover market plays a more effective disciplining role on management, it could lead to a reduction in managerial agency costs. In addition, gains may come from the special role of banks in reducing information costs as well as the costs of distorted risk-taking incentives by firms. It is this latter aspect of universal banking that we focus on in this paper. Specifically, we analyze how bank-commerce interrelationships - in this case banks holding equity stakes in firms - affect the overall risk-taking of firms and by implication the risk exposure of banks. Indeed, concerns about increased risk exposure of banks, and by implication to the federal safety net (deposit insurance, payment system guarantees and the discount window), lie at the heart of much of the opposition to universal banking. In this paper we consider the objectives and incentives of the bank regulator, the bank (banking sector) and commercial firms with and without bank ownership in commercial firms. The objective of the social planner (regulator) is formulated to be increasing in the liquidity services provided by banks and in the efficiency of investments undertaken by the commercial sector, while decreasing in the variance (risk) of bank asset portfolios. This formulation of the objective function allows for potential increases in efficiency of investment (in an environment of moral hazard) due to enhanced and more direct bank-commerce links, as well as costs to the regulator of increased risk to the banking sector resulting from more direct bank-commerce links, i.e., banks holding explicit equity stakes in firms First, we consider the case of a bank which does not take a controlling
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role in the investment decisions of the borrowing firm. The investment policy of the firm (in particular the choice between risky and riskless investments) is controlled by corporate insiders and not the bank equity holder. However, the incentives of insiders are influenced by the compensation structure in place and the structure of claims held by them (and the bank). The risk of the bank’s portfolio and the value of the firm’s investment policy is then characterized for various combinations of debt and equity holdings by the bank. Interestingly, the efficiency of investment increases and the risk of the bank portfolio decreases with increased equity ownership in a firm by the bank. Although, for a given investment policy, larger equity ownership increases the risk of the bank’s assets, the debt-equity structure of the bank’s claims influences the investment policy of the firm in such a manner that the combined effect is to reduce the bank’s risk with equity ownership. In other words, the social planner’s (regulator’s) objective is higher with universal banking. Secondly, we consider a scenario where the bank exercises limited control over the firm’s investment policy. Here, the bank is allowed to veto any risky project proposed by insiders. In this case, a bank which only holds debt is overly conservative and the use of its veto power induces a suboptimal lowrisk investment policy by the firm. By allowing the bank to hold some equity, the bank’s veto implements a riskier-than-before investment policy which is shown to be more efficient. In this scenario there is a clear trade-off between firm investment efhciency and bank asset risk. With a larger equity holding by the bank, a firm’s investment becomes more and more efficient but the bank’s assets become more and more risky. Consequently, as bank equity holdings increase, firm efficiency improvements increase the value of the regulators objective function while increases in bank risk decrease the value of that function. The nature and shape of this trade-off determines the optimal equity ownership for the bank. The remainder of the paper is organized as follows. The basic model is laid out in Section 2. Here we characterize the investment policy of the borrowing firm. The Pareto-optimal policy is characterized as a benchmark for firm investment efficiency. Investment distortions caused by risky debt, such as overinvestment in the risky project, are also characterized. The main analysis is contained in Section 3. In Section 3.1, we study the case of firm insider-controlled investments, i.e., where investment choice is made by corporate insiders of the borrowing firm irrespective of the size of the bank’s equity ownership in the firm. For different levels of bank ownership in the borrowing firm, its investment policy, its value and the risk of the bank asset portfolio are characterized. In Section 3.2, we examine the case of a ‘controlling bank’ which has the information and the right to veto any risky investment project. Again, the details of the investment policy and the bank risk associated with different bank equity ownership levels are characterized.
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The socially optimal level of bank equity ownership is also characterized. Section 4 concludes.
2. The model For simplicity, consider a representative depository institution (bank), a borrowing firm (the firm) and a social planner (the regulator). The bank is the sole source of external financing for the firm. The required financing is structured as debt only in a regime with a separation of banking from commerce. We consider two scenarios of control by the bank over the investment choices of the firm: first, the firm controls its investment policy and the bank is modelled as a non-controlling external investor holding debt and/or equity. In the second case the bank does control the firm’s investment policy: it has the right to veto risky projects proposed by corporate insiders. Consider the representative firm and its investment opportunity set. The risk choices made by the manager (or corporate insiders) of the firm are modelled as ‘private actions.’ That is, there is less-than-perfect external monitoring of these risk choices by outsider investors (including the bank and the regulator) and consequently there is ‘incomplete contracting’ vis-a-vis these choices. Imperfect observability of private action (and resulting incomplete contracting) lie at the heart of agency problems, and are crucial for the analysis that follows. It is convenient, for expositional purposes, to view the world within a three-date two-period framework. At t=O the bank extends the financing required for investment, specified to be I dollars to the firm in return for a fraction c(, 0 < c1< 1, of equity of the firm and debt of face value F, F > 0. For simplicity we assume that the debt consists of a pure discount bond which matures at date t=2. The values (prices) of debt and equity are determined in a rational-expectations manner. The total value of debt and equity held by the bank is I dollars. The investment opportunities of the firm materialize at t= 1. For simplicity it is assumed that the investment opportunity set available to the firm consists of two types of project. There is a safe project with zero net present value (e.g., riskless bonds). An investment of I dollars made at t= 1 results in a return of Z dollars at t=2 (a zero risk-free rate of interest is assumed for simplicity). The second project is a risky project indexed by a parameter q. This project requires an investment I to be made at t = 1 and the resulting returns are high or low (H dollars or L dollars, respectively) with H > I> L> 0,and where q is the probability of the high outcome H and (l-q) is the probability of the low outcome, L. Who has information about the quality of the project (i.e., parameter q) at t = 1 is a crucial feature of the model. Except in Section 3.2, when we study
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311
the case of the controlling bank, it is assumed that only the firm’s managers (the corporate insiders) observe 4. Other agents, such as the bank and the regulator, do not observe q at t= 1. This precludes any contracting (either managerial contracts or debt covenants) contingent on the value of the parameter (q). However, all the relevant parties know that q is distributed uniformly over the interval [OJ]. This modeling device captures the intuition that, given any efficient level of monitoring undertaken by the bank and regulators, firm managers have additional information about the details of the firm’s technology and its risk through inside knowledge of the parameter q. In what follows, it will be clear that the manager makes the firm’s investment risk choice ‘privately.’ That is, the manager decides between the risky project and the riskless project based on his private observation of q at t=l. At t =2 cashflows are realized from investments made at t = 1. Let p denote this terminal cashflow which is equal to I if the riskless investment was chosen at t = 1, or equal to H or L depending on the outcome from the risky investment if that choice was made at t = 1. Payments are made to the bank to settle the external financing claims (debt or equity) held by the bank. For simplicity we will assume that the bank and shareholders will use riskneutral valuation of the terminal cashflows accruing to their respective claims to value their contracts. However, this valuation will rationally incorporate the investment policy which is endogenously determined given the structure of financing claims held by the bank and the residual ones held by the firm. For debt of any face value F and equity of fractional ownership CCof the residual cashflows, the bank pays the firm its current prices B(F,a) and E(F,a), which are computed in a rational expectations manner taking into account the investment policy induced by the financing claims F and c1 in place. Of course, we consider only feasible financing policies {Fp} satisfying the resource balance condition, B( Fp) + aE( Fp) = I. The firm insiders (managers) act to maximize the wealth of the residual claimants (insiders and other (bank) shareholders). 2.1. Investment
policy of an all-equity firm
In this section the investment policy of the firm, in a scenario with complete contracting, is characterized. This is equivalent to the investment policy of a firm, financed with only riskless debt and equity. Manager’s investment choice at t = 1, after observing q, is as follows. Invest in the risky project only if: qH+(l--q)LaI That
is, the manager
invests
in the risky project
only if it yields a higher
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K. John et al. 1 Journal of Banking and Finance 18 (1994) 307-323
Fig. 1. Distribution of terminal cashflows resulting from an investment policy [a. If the manager pursues an investment policy [q], i.e., invests in the risky project for q>Q, since q is uniformly distributed on [O,l], the probabilities of obtaining the linal outcome of H, I and Lare as shown above.
present value than investing in the riskless project, which yields a zero net present value. Denote as 4 the lowest (cut-off) value of CJwhich satisfies (1) the riskless one. such that the risky investment dominates That is, 1 I-L 4=&L.
(2)
The investment policy in (1) is equivalent to investing in the risky project for all values of q such that qz:(i. The above investment policy is the one which could have been achieved if q were perfectly observed by all parties and if a complete set of enforceable contracts specifying any investment policy could have been written. The following definition facilitates a discussion and comparison of various investment policies: Definition 1: An investment policy of investing in the risky project for all q>cj will be denoted as investment policy [il. An investment policy [G] produces the distribution of terminal cashflows displayed in Fig. 1 (given that q is uniformly distributed on [O,l].) Based on Fig. 1, and given risk-neutral pricing of terminal cashflows, the present value of an investment policy [
(3)
K. John et al. ! Journal of 3anking and Finance. 18 (1994)
307-323
313
Using Eq. (3) and the Pareto optimal investment policy [&j cha~cterized in (l), the highest present value V(g) achievable from the firm’s technology can be specified as follows:
3=v(~)=BI+~[1-~]2+~cl -(i2]
(4)
Clearly the investment policy [a], where 4 is given in (I), and the resulting value k’(4) specified in (4) forms a useful benchmark to measure the ~stortions caused by suboptimal financing packages. If a su~ptimal financing structure induced an investment policy [a, with present value V(g), then the value lost through suboptimal financing and resulting inefficient investment is P- V(@. It should be apparent that the cut-off level of 4, say @,which determines the investment policy [G] determines the riskiness of the distribution of terminal cashflows realized at t=2 (shown in Fig. 1). The lower the cut-off used, the more likely it is that the risky investment is undertaken and the riskier the distribution of terminal cashflows. From the terminal cashflow distribution in Fig. 1, for q1
When the bank is not a controlling bank and is holding on to debt of face value F >L, it is well known that the insiders have incentives to pursue investment policies which are riskier and less efficient than [G]. Proposition 1 collects some results on the investment policy of the firm when it is financed with some debt. (a) With debt of promised payment F>O, the manager will implement an investment policy [q(F)], where q(F) is given in Eq. (5): q(F)=4
when FGL
I-F =-.-.---. when L
(5)
=0 when F2.I. (b) When the debt is risky, i.e., F> L the manager implements an investment pohcy which is suboptimal and riskier than the Pareto optimal one, [Q].
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(c) In the range of F,L< F
resulting is strictly
1.
Two important insights follow from Proposition 1, (b) and (c). If the bank were to provide financing of I, partly through equity claims, then the required face value of debt needed by the firm will be lower and the implemented investment policy will be less risky than in the all debt case. Although the banks’s holding of equity suggests a riskier bank portfolio, this effect may be offset by the reduced riskiness of the firm’s implemented investment policy. In other words, the risk of the bank’s portfolio is affected by the structure of claims it holds in borrowing firms not only through the nature of the claims (debt us equity) but also through the riskiness of the induced investment choices made by the firm.
2.3.
The social planner’s (regulator’s)
objective
In the debate on the advisability of eliminating the separation between banking and commerce, several social goals may play a role. As mentioned in the introduction, our focus will be on: (1) the benefits of universal banking in improving firms investment efficiency, and (2) potential costs from increased risk to the banking sector. To be more specific let {a,F(or)} be a feasible financing package used by the bank, i.e., aE(cl,F) +B(cr,F)=I, where E( .) and B( .) are the prices of equity and bank debt, anticipating the investment policy [q(F(cc))] induced by such a financing package {a,F(cr)). We use V(a) to denote the total present value resulting from the investment policy [q(F(a))] and L?(U) to denote the variance of the terminal cashflow or asset risk, min{p,F}+cr(p-F)+, which accrues to the bank. The social objective S(N) is an increasing function of V(m) and a decreasing function of Q(a). If the maximal value of S is attained when a* = 0, then the current separation of commerce and banking is socially optimal. If it is attained when a* >O, then universal banking with bank equity ownership of a* is optimal. In Section 3 we will analyze the behavior of V(a) and @CC)when CYis increased from 0 to &=(I-- L)/V for two different scenarios of firm investment policy control by the bank. In the case of the non controlling bank, V(R) increases with cc,Odcc< B and Q(a) - asset risk decreases with a,Od c1< 8. Here the social objective is maximized at &> 0. In the case of the controlling bank it will be shown that V(g) increases with cr,O
K. John et al. / Journal of Banking and Finance I8 (1994) 307-323
Q(N). In this case cr*,O
degree
of bank
315
equity-
3. Efficiency, risk and universal banking In this section we will examine the investment efficiency and risk of the bank portfolio for different degrees of bank equity ownership in the borrowing firm. Intuitively it might be thought that the risk of a bank’s portfolio should increase with higher levels of bank equity holdings in the firm. This, however, ignores the effect of the debt-equity (capital) structure of financing claims on firm (the insiders’) incentives, which in turn, determines their investment project choice and its risk. The investment choice implemented will, in addition, depend on the degree of control exercised by the bank over the investment policy of the borrower firm. In the following sections we will characterize the relationships between ownership structure and efficiency of investment, and between ownership structure and the risk of the bank portfolio in two regimes: (1) firm insiders control investment policy and (2) the bank controls firm investments policy through its right to veto risky projects.
3.1. Firm-controlled
investment
In this section we extend the basic model of Section 2 to examine the scenario of investment under moral hazard and imperfect information. Corporate insiders are now assumed to privately observe 4, the quality of the risky investment, and to choose the investment (risky project or riskless project) in their own best interests. In this sub-section the bank is assumed to be a financier only, and claims are restricted to be debt of face value, F 2 0 and an ownership fraction a,Odcr< 1, of the firm’s equity. For any given value of F, the insiders choose an investment policy [q(F)] described in Proposition 1. Rational pricing of bonds as B(a,F) and equity as E(LY,F) take into account the investment policy [q(F)], characterized in (5), induced by {a,F(cr)}. A feasible financing mix {cr,F} satisfies the resource balance condition, B(c(,F) + c&(cl,F) = I
(6)
Since our focus is on the ‘social value’ of universal banking we will examine the investment efficiency achieved under different ownership levels of the firm by the bank and the resulting risk of the bank’s position {cc,F). For any a, we can characterize a level of promised payment on debt F, say F(a),
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K. John et af. 1 Journal of Banking and Finance I8 ( 1994) 307-323
such that the resource balance Eq. (6) is satisfied. For the feasible financing package {@(IX)) we can denote the present value of total terminal cashflows obtained from the investment policy [q(F(cr))] as V(g); the variance of the bank’s total cashflows at t=2 can be denoted as Q(a). For a financing package {&,L) the Pareto optimal investment policy will be implemented (see Eq. (5)). Denote the value of terminal cashflows as P and the risk of the bank’s cash flows as 6. First, we wili prove a result about the level of debt required and the investment policy implemented if the ~nan~ing package does not have any (non-controlIing) equity ownership by the bank. Proposition 2: If I > L and a=O, the only feasible level of promised payment, F, equals (2Z- L). The investment policy implemented is CO], i.e., the risky project is always chosen. The resulting value, V(0) is (H f L)/2, and the variance of the bank’s position, Q(O), equals (I - L)2. Proof: First, note that F <:I will not satisfy the resource-balance condition, when c(= 0. For F> I, the investment policy implemented is [0] from Proposition 1. Given that the resulting terminal distribution is H with probability $ and L with probability $, straightforward computation yields F=(2Z--L), V=(H+L)/2 and 52=(1--L)‘.[7
Proposition 2 emphasizes the role of the implemented investment policy in determining the risk of the bank’s portfolio. Even though the bank holds no equity in the firm, the face value of debt needed to satisfy the resource balance condition is high (anticipating the risky investment policy that will be implemented). By substituting some of this debt with equity, the riskshifting incentives of the firm are curtailed resulting in a safer investment policy. The next proposition shows that it is possible that the reduced risk of the firm’s investment policy may make the risk of the bank portfolio lower even though it now holds an equity stake in the borrowing firm. Proposition 3: Again, consider I> L. With the financing package {&,LI where d=(Z- L)/e the Pareto optimal investment policy [G] is implemented, resulting in value @and bank risk b<(Z -L)2. Proof With F= L, the investment policy implemented is seen to be [G] from Eq. (5). Direct computation of the variance of the bank’s position, L+$(PL), (where P is the realized cashflow H, Z or L) shows that Q(k)=f(Z-L)*, where
Now, 6’>(H + L)/2 and (H-L) This in turn implies b<(Z-_)‘.a
<(H + L) can be shown to imply that f < 1.
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317
This proposition implies that by going to a financing package with an ownership fraction & and purely riskless debt (of promised payment L) the bank actually reduces the risk of its portfolio, compared to the financing of Proposition 2 with only debt and no equity ownership. Moreover, the efficiency of investment policy increases from [0] to [g] with attendant value increase from (H+ L)/2 to f? In fact, it can be shown that the efficiency and risk gains achieved as ~1increases from 0 to & is monotonic. P~o~o~~~~o~4: Consider the family of financing packages ja,F(a)),O< a< =B, where the extreme package (0,21--L) and (a&> were considered in Proposition 3. For a,OO) and S,
As the bank’s equity ownership goes from 0 to 0.6 the firm’s debt level goes from 2 to 0. The firm’s value goes from lf to 13 and the risk of the bank portfolio goes from I to 0.56. The social objective is maximized at &=0.6, i.e., at 6074 of equity ownership in the firm by the bank. The above relationships are also displayed in graphs (Fig. 2) and (Fig. 3) along with the corresponding graphs for the case of bank-controlled investment discussed in the next sub-section (Section 3.2).
3.2. Bank-controlled investment In this sub-section we examine the case of the bank having some veto control over investment decisions by the firm. The role of the bank having control over the firm’s investment decisions is in the spirit of banking theory models which depict banks as delegated monitors or ‘main banks’ supplying funds to firms in a world of imperfect and asymmetric information. Several
318
K. John et af. / Journal of Banking and Finance 18 j1994) 307-323 Table 1 Firm-controlled c1
0
0.05 0.1
0.2 0.3 0.4 0.4784 0.48 0.49 0.5 0.55 0.57 0.6
investment
q(F) L.
1.9474 1.8889 1.75 1.5714 1.3333 0.81 0.7432 0.6266 0.5505 0.2629 OS582 0
(F)
f’CdF)I
Variance
0 0 0 0 0 0
1.5
1 1 1 1 1 1 0.7829 0.7318 0.6647 0.633 0.5703 0.5626 0.56
0.0868 0.1138 0.1573 0.1835 0.2693 0.2962 0.3333
1.5
1.5 1.5 is 1.5 1.5755 1.5944 1.6202 1.633 1.6605 1.6646 1.6667
This table displays the value of total terminal cash flows V(q(F)) and variance of bank asset portfolio for different values of bank ownership a, the debt level F which satisfies the resource balance condition (6) and the induced investment policy [q(F)].
Fraction of equity owned by bank
Fig. 2. Bank ownership and investment efficiency.
K. John et al. / Journal of Banking and Finance 18 (1994) 307-323
.-0
1
$ 2
0.8-
Y 5 D
0.6-
319
75 8 s s‘E
0.40.20 0
,,,..,.... ?.“’ ,,I.,,.“. .a’_’ ,,.,,,..... “’ ,,,_ ,.,_..... .““’ .,,(,, _...“.l....~‘u”’ _.“....... .““’ ,,,,_.,,,,,.,......... ..”,_,.((,,,, ,,_......_..-. I I I I 0.3 0.4 0.1 0.2 Fraction of equity owned by bank
-
Firm Control
Fig. 3. Bank ownership
I 0.5
0.6
.-.....‘....-..Bank Control
and bank portfolio
risk.
researchers (e.g., Fama, 1985) have argued that lending puts banks in the position of privileged quasi-insiders or informed lenders. In this position a bank may exercise both monitoring and control over the type of the projects (and their risk) chosen by the firm. In our model we capture the idea of the bank having some control over the investment decision by the following device. When the firm’s corporate insiders propose investment in a risky project after observing 4 at t= 1, the bank has the right to veto that project. In which case, the investment is then made in the riskless project (riskless bonds). Here the bank does obtain information about 4, the quality of the risky project. It vetoes the project if it is in its interest to do so given the structure the financing claims {cr,F} it holds in the firm. When the bank holds claims {CT@},its share of the terminal cashflows P( =H,I or L) equals min{F,P} + ctmax{P-F,O}, since the bank would veto the risky project when it is not in its interest for the firm to undertake it. We can characterize the investment policy [@I as the one which will be implemented when the bank has the veto power. Proposition 5: In the case of bank-controlled investment policy, when the bank holds claims {cr,F}, it will veto all risky projects with q
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Ffl--ct)+af-L
whenL
qc=F(l-a)+aH-L’ I-L *C=Fjl-n)+a&-i
(8)
when F>sl
The implemented investment policy is [q”]. Proa$ Holding project, iE
claims (a,F) the bank will refrain from vetoing a risky
where quantity (4)’ z max{0,4). N ow the cut-off probability qf is the lowest value of q which satisfies (9), as an equality. Solving for the relevant range of F we obtain Eq. (8). Since q” is always larger than q(F) (characterized in Eq. (5)), which is the cut-off used for proposals by corporate insiders, the bank’s vetoes are binding. Therefore, the implemented investment policy is [@].O Now that we have characterized the investment policy [q’] that will be implemented under bank-control, we can examine investment efficiency and bank asset risk for various feasible financing packages held by the bank. The procedure is similar to that followed in Section 3.1, although some of the results are different. The financing package (OJ) is a feasible one and a very conservative investment policy if implemented. The value of terminal cash flows is merely I (the investment being in the riskless asset for all values of 9) and the variance of the bank’s cash flow is zero. Although the risk is low, the loss in terminal value, ( P-Z), is very high. Similarly (12,L) is also a feasible ~nan~ing package. (Recall B= (I - L)/?). The investment policy implemented is [ii] with attendant value of Pand the variance of the bank’s portfolio is 6. Compared to the case above with financing package (0, I>, the investment efficiency has gone up from I to P but the bank risk also has gone up from zero to 6. Now there is a genuine return-risk trade-off from increasing the ownership structure of banks, since enhanced investment efficiency is attained at a cost of increased risk in the banking system. As before, our focus is on the social value of universal banking as reflected by firm investment efficiency and bank risk for various levels of the bank’s equity ownership in the borrowing firm. For any equity ownership fraction cr,OdccCL?, we can determine F(a) given by the resource balance condition (6) and the corresponding investment policy [q’] in (8). For all feasible financing packages (a,&‘(a)> we characterize the value of total terminal
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307-323
321
Table 2 Bank-controlled
investment
a
F
0
1
1
1
0
0.05
0.9952 0.9812 0.9254 0.826 0.6667 0.4747 0.4416 0.4142 0.2341 0.148 0
0.9087 0.831 0.7016 0.5941 0.5 0.4309 0.4225 0.4142 0.3733 0.3573 0.3333
1.1701 1.2952 1.4633
0.005 0.0197 0.0764 0.1652 0.28 0.3862 0.400 1 0.4142 0.4862 0.5156 0.56
0.1 0.2 0.3 0.4 0.48 0.49 0.5 0.55 0.57 0.6
Vq’)
Variance
1.5647 1.625 1.6524 I.6547 1.6569 1.6643 1.6658 1.6667
This table displays the value of total terminal cashflows V(q’) and variance of bank asset portfolio for different values of bank ownership a, the debt level F which satisfies the resource-balance condition (6) and the induced investment policy [q’].
cashflows V(a) and the risk of bank portfolio Proposition 6 holds:
Q(E). It can be shown that
Proposition 6: Consider the family of financing packages {a,F(a))),Od cl<& where the extreme packages (0, 11 and {a, Lf were discussed above. For cr,Od cr<&,V(ol) is increasing in 01from V(O)=I to V(e)= l? Similarly, for a,0 < TV < B, 52(a) is increasing in cI from Q(O)= 0 to Q(B)= Sz> 0.
This proposition shows that the relationship between firm investment efficiency and bank equity ownership is a monotonically increasing one (as in the case of firm-controlled investment). However, the risk of the bank’s portfolio is increasing in bank equity ownership in the firm (opposite to the case when insiders in the firm controlled investment policy). Since the social objective function S(E) is increasing in V(g) but decreasing in L?(a) it is clear that increased bank ownership poses a real social welfare trade-off. The optimal level of bank ownership, a*, will be determined by the trade-off (value weights) implied in the social objective function, S(a). Example 2: In this example for the bank-controlled investment case, we use the same parameters, H = 3, L,= 0 and I = 1 as in example 1. Different levels of bank equity ownership a, 06 aGO.6, the corresponding level F(a) of debt (subject to resource balance condition (6)), resulting investment policy [qC(F,a)], value of total terminal cashflows V(a), and the variance of the bank’s terminal cashflows, Q(a) are all listed in Table 2.
As the ownership goes from 0 to.6, the debt level goes from I to 0. The
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firm’s value goes from 1 to 15 while, the risk of the bank portfolio increases from 0 to 0.56. These relationships are also displayed in Figs. 2 and 3 along with the corresponding case of firm-controlled investment discussed in the previous section (Section 3.1). In the case of bank-controlled investment, the value of c(, say LX*,which maximizes S(U), will not, in general, be equal to B, and it may be in the interior of [0, a].
4. Conclusion Several interrelated costs and benefits enter into the debate on the merits of eliminating the separation of commerce and banking. In this paper we have focused on two aspects. On the benefit side we examine how bank ownership of equity in firms may contribute to investment efficiency in an environment with private information and moral hazard. On the cost side we consider the asset risk to the banking system from holding both debt and equity claims in firms. A commonly raised concern is that equity ownership by banks in borrowing firms increases the risk of the bank portfolios and this will in turn impose increased potential costs on the Central Bank, the deposit insurance system and the payment system (the so-called federal safety net). The setting for our analysis was one of moral hazard in which the risk choices in investment policy made by corporate insiders were ‘private actions,’ and the financing of the representative firm was undertaken by a single bank. The social planner’s objective was modelled as being increasing in firm investment efficiency but decreasing in the risk (variance) of the bank’s asset portfolio. The structure of claims held by the bank on the firm (i.e., the bank’s asset structure) and the degree of control exercised by the bank over the firm’s investment policy were shown to be major determinants of the firm’s endogenous choice of investment risk. We studied two regimes of bank control of investments which were shown to affect firm investment efficiency and bank risk in important (and different) ways. In the case where insiders of the firm controlled investment, increases in a bank’s ownership of the borrowing firm’s equity increased investment efficiency and reduced the variance (risk) of the bank’s portfolio. The risk of increased equity ownership by the bank in the firm is offset by its effect in inducing a more conservative investment policy as a result of the firm having a lower leverage debt-equity ratio. Since both effects of increased equity ownership increase the value of the regulator’s objective, when insiders of the firm control investment policy, bank ownership of firm’s equity is unambiguously of social value. The results are more mixed in the case where the bank exercises more
control, i.e., the bank has a veto over the risky projects proposed by corporate management. In this case investment efficiency is increasing in the level of firm’s equity held by the bank. However, the ,asset risk of the bank portfolio also increases. As a result investment efficiency and risk have offsetting effects on the social objective function and the optimal bank equity ownership share is determined by this trade-off.
References Bertin, M, K. John and A. Saunders, 1993, Should banks hoId equity in borrowing firms? (Stern School of Business, New York University, W.P.). Corrigan, E.G., t987a, Financial market structure: a longer view (Federal Reserve Bank of New York), January. Corrigan, E.G., 1987b, The separation of banking and commerce statement before U.S. Senate Committee on Banking. Housing and Urban Affairs, 18th June (also as Appendix V Statement before the same Committee May 3, 1990). Fama, E.F., 1985, What’s different about banks? Journal of Monetary Economics, 29-40. Hoshi, T., A. Kashyap and D. Sharfstein, 1990, The role of banks in reducing the costs of financial distress, Japan Journal of Financial Economics 27, 67-88. James, C,, 1987, Some evidence on the uniqueness of bank loans. Journal of Financial Economics 19, 217.-235. John, K. and T.A. John, 1993, Top-management com~nsation and capital structure, Journal of Finance 48,949-974. Rothschild, M. and J. Stiglitz, 1970, Increasing risk I: A definition, Journal of Economic Theory 2, 225-243. Rothschild, M. and J. Stiglitz, 1971, Increasing risk II: Its economic consequences, Journal of Economic Theory 3, 66-84. Saunders, A., 1994, Banking and commerce: an overview of the public policy issues, Journal of Banking and Finance 18, 231-254. Saunders, A and I. Walter, 1994, Universal banking in the United States. What could we gain? What could we lose (Oxford University Press, New York). U.S. Treasury, 1001, Modernizing the financial system: recommendations for safer more competitive banks (Department of Treasury, Washington, DC).
Journal
of Banking
and Finance
18 (1994) 307-323
Universal banking and firm risk-taking Kose John*, Salomon Brothers
Teresa
A. John
and Anthony
Saunders
Center, Leonard School of Business, New York University, New York, NY 10012, USA Final version
received December
44 West 4th Street,
1993
Abstract
This paper analyzes the welfare implications of banks taking equity stakes in firms under conditions of imperfect information and moral hazard. Two cases of bank control over investment decisions are analyzed. In the first, the bank does not control the investment decisions of the firm. Here, the investment efficiency is higher and bank risk is lower for an optimal positive level of bank equity holdings. However, in the case when the bank has veto power over investment proposals by the firm, there is a trade off between increased investment efficiency and increased bank risk. Key words: welfare
Universal banking;
JEL class@ation:
Risk-taking;
Commerce; Investment
efficiency; Social
G21, G24, G28
1. Introduction While many observers agree that the structure of the U.S. banking industry is in need of reform, there are wide disagreements over what should be done. One of the major areas of debate is over whether the current separation (and restrictions) between commerce and banking should be relaxed in any future restructured financial system. In the U.S. a number of regulatory reports have considered, either directly or indirectly, the costs and benefits of bank-commerce interlinks. For example, reports issued by Corrigan (1987a,b) were generally opposed to relaxing, the current separation between banking and commerce. On the *Corresponding
author We are grateful to Mitchell Berlin, Loretta Mester, Manju Puri and Anjan Thakor for helpful discussions. Kose John acknowledges research support from a Bank and Financial Analysts Faculty Fellowship, Teresa John from a New York University Summer Research Grant and Anthony Saunders from the John M. Schiff Chair. 0378-4266/94/$07.00 0 1994 Elsevier Science B.V. All rights reserved SSDI 0378-4266(93)EOO63-T
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other hand, the more recently issued Treasury Report (1991) went in the opposite direction advocating the establishment of commercial firm owned financial service holding companies. There is a highly complex set of interrelated costs and benefits to relaxing the separation between banking and commerce (for a discussion of the public policy costs and benefits, see Saunders, 1994). Potential benefits may be grouped into two categories. In the first category we can consider potential sources of value arising from the combined operation of a bank and a commercial firm. For example, if a bank is acquired by a commercial firm (or vice versa) and the depository institution grows in size as well as in the scope of its activities (product mix is larger) its average (unit) costs of producing banking services may decline resulting in economies of scale and/ or economies of scope. In addition to savings on costs, revenue gains may also result from an increased organizational efficiency of the combined firm. Further, product and geographic diversification benefits from the bankcommercial firm conglomerate organization may also generate value gains by reducing the costs of financial distress and contracting. A second category of benefits, from integrating banking and commerce, may come from reducing agency costs and the costs of asymmetric information. For example, if the resulting less restricted takeover market plays a more effective disciplining role on management, it could lead to a reduction in managerial agency costs. In addition, gains may come from the special role of banks in reducing information costs as well as the costs of distorted risk-taking incentives by firms. It is this latter aspect of universal banking that we focus on in this paper. Specifically, we analyze how bank-commerce interrelationships - in this case banks holding equity stakes in firms - affect the overall risk-taking of firms and by implication the risk exposure of banks. Indeed, concerns about increased risk exposure of banks, and by implication to the federal safety net (deposit insurance, payment system guarantees and the discount window), lie at the heart of much of the opposition to universal banking. In this paper we consider the objectives and incentives of the bank regulator, the bank (banking sector) and commercial firms with and without bank ownership in commercial firms. The objective of the social planner (regulator) is formulated to be increasing in the liquidity services provided by banks and in the efficiency of investments undertaken by the commercial sector, while decreasing in the variance (risk) of bank asset portfolios. This formulation of the objective function allows for potential increases in efficiency of investment (in an environment of moral hazard) due to enhanced and more direct bank-commerce links, as well as costs to the regulator of increased risk to the banking sector resulting from more direct bank-commerce links, i.e., banks holding explicit equity stakes in firms First, we consider the case of a bank which does not take a controlling
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role in the investment decisions of the borrowing firm. The investment policy of the firm (in particular the choice between risky and riskless investments) is controlled by corporate insiders and not the bank equity holder. However, the incentives of insiders are influenced by the compensation structure in place and the structure of claims held by them (and the bank). The risk of the bank’s portfolio and the value of the firm’s investment policy is then characterized for various combinations of debt and equity holdings by the bank. Interestingly, the efficiency of investment increases and the risk of the bank portfolio decreases with increased equity ownership in a firm by the bank. Although, for a given investment policy, larger equity ownership increases the risk of the bank’s assets, the debt-equity structure of the bank’s claims influences the investment policy of the firm in such a manner that the combined effect is to reduce the bank’s risk with equity ownership. In other words, the social planner’s (regulator’s) objective is higher with universal banking. Secondly, we consider a scenario where the bank exercises limited control over the firm’s investment policy. Here, the bank is allowed to veto any risky project proposed by insiders. In this case, a bank which only holds debt is overly conservative and the use of its veto power induces a suboptimal lowrisk investment policy by the firm. By allowing the bank to hold some equity, the bank’s veto implements a riskier-than-before investment policy which is shown to be more efficient. In this scenario there is a clear trade-off between firm investment efhciency and bank asset risk. With a larger equity holding by the bank, a firm’s investment becomes more and more efficient but the bank’s assets become more and more risky. Consequently, as bank equity holdings increase, firm efficiency improvements increase the value of the regulators objective function while increases in bank risk decrease the value of that function. The nature and shape of this trade-off determines the optimal equity ownership for the bank. The remainder of the paper is organized as follows. The basic model is laid out in Section 2. Here we characterize the investment policy of the borrowing firm. The Pareto-optimal policy is characterized as a benchmark for firm investment efficiency. Investment distortions caused by risky debt, such as overinvestment in the risky project, are also characterized. The main analysis is contained in Section 3. In Section 3.1, we study the case of firm insider-controlled investments, i.e., where investment choice is made by corporate insiders of the borrowing firm irrespective of the size of the bank’s equity ownership in the firm. For different levels of bank ownership in the borrowing firm, its investment policy, its value and the risk of the bank asset portfolio are characterized. In Section 3.2, we examine the case of a ‘controlling bank’ which has the information and the right to veto any risky investment project. Again, the details of the investment policy and the bank risk associated with different bank equity ownership levels are characterized.
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The socially optimal level of bank equity ownership is also characterized. Section 4 concludes.
2. The model For simplicity, consider a representative depository institution (bank), a borrowing firm (the firm) and a social planner (the regulator). The bank is the sole source of external financing for the firm. The required financing is structured as debt only in a regime with a separation of banking from commerce. We consider two scenarios of control by the bank over the investment choices of the firm: first, the firm controls its investment policy and the bank is modelled as a non-controlling external investor holding debt and/or equity. In the second case the bank does control the firm’s investment policy: it has the right to veto risky projects proposed by corporate insiders. Consider the representative firm and its investment opportunity set. The risk choices made by the manager (or corporate insiders) of the firm are modelled as ‘private actions.’ That is, there is less-than-perfect external monitoring of these risk choices by outsider investors (including the bank and the regulator) and consequently there is ‘incomplete contracting’ vis-a-vis these choices. Imperfect observability of private action (and resulting incomplete contracting) lie at the heart of agency problems, and are crucial for the analysis that follows. It is convenient, for expositional purposes, to view the world within a three-date two-period framework. At t=O the bank extends the financing required for investment, specified to be I dollars to the firm in return for a fraction c(, 0 < c1< 1, of equity of the firm and debt of face value F, F > 0. For simplicity we assume that the debt consists of a pure discount bond which matures at date t=2. The values (prices) of debt and equity are determined in a rational-expectations manner. The total value of debt and equity held by the bank is I dollars. The investment opportunities of the firm materialize at t= 1. For simplicity it is assumed that the investment opportunity set available to the firm consists of two types of project. There is a safe project with zero net present value (e.g., riskless bonds). An investment of I dollars made at t= 1 results in a return of Z dollars at t=2 (a zero risk-free rate of interest is assumed for simplicity). The second project is a risky project indexed by a parameter q. This project requires an investment I to be made at t = 1 and the resulting returns are high or low (H dollars or L dollars, respectively) with H > I> L> 0,and where q is the probability of the high outcome H and (l-q) is the probability of the low outcome, L. Who has information about the quality of the project (i.e., parameter q) at t = 1 is a crucial feature of the model. Except in Section 3.2, when we study
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the case of the controlling bank, it is assumed that only the firm’s managers (the corporate insiders) observe 4. Other agents, such as the bank and the regulator, do not observe q at t= 1. This precludes any contracting (either managerial contracts or debt covenants) contingent on the value of the parameter (q). However, all the relevant parties know that q is distributed uniformly over the interval [OJ]. This modeling device captures the intuition that, given any efficient level of monitoring undertaken by the bank and regulators, firm managers have additional information about the details of the firm’s technology and its risk through inside knowledge of the parameter q. In what follows, it will be clear that the manager makes the firm’s investment risk choice ‘privately.’ That is, the manager decides between the risky project and the riskless project based on his private observation of q at t=l. At t =2 cashflows are realized from investments made at t = 1. Let p denote this terminal cashflow which is equal to I if the riskless investment was chosen at t = 1, or equal to H or L depending on the outcome from the risky investment if that choice was made at t = 1. Payments are made to the bank to settle the external financing claims (debt or equity) held by the bank. For simplicity we will assume that the bank and shareholders will use riskneutral valuation of the terminal cashflows accruing to their respective claims to value their contracts. However, this valuation will rationally incorporate the investment policy which is endogenously determined given the structure of financing claims held by the bank and the residual ones held by the firm. For debt of any face value F and equity of fractional ownership CCof the residual cashflows, the bank pays the firm its current prices B(F,a) and E(F,a), which are computed in a rational expectations manner taking into account the investment policy induced by the financing claims F and c1 in place. Of course, we consider only feasible financing policies {Fp} satisfying the resource balance condition, B( Fp) + aE( Fp) = I. The firm insiders (managers) act to maximize the wealth of the residual claimants (insiders and other (bank) shareholders). 2.1. Investment
policy of an all-equity firm
In this section the investment policy of the firm, in a scenario with complete contracting, is characterized. This is equivalent to the investment policy of a firm, financed with only riskless debt and equity. Manager’s investment choice at t = 1, after observing q, is as follows. Invest in the risky project only if: qH+(l--q)LaI That
is, the manager
invests
in the risky project
only if it yields a higher
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K. John et al. 1 Journal of Banking and Finance 18 (1994) 307-323
Fig. 1. Distribution of terminal cashflows resulting from an investment policy [a. If the manager pursues an investment policy [q], i.e., invests in the risky project for q>Q, since q is uniformly distributed on [O,l], the probabilities of obtaining the linal outcome of H, I and Lare as shown above.
present value than investing in the riskless project, which yields a zero net present value. Denote as 4 the lowest (cut-off) value of CJwhich satisfies (1) the riskless one. such that the risky investment dominates That is, 1 I-L 4=&L.
(2)
The investment policy in (1) is equivalent to investing in the risky project for all values of q such that qz:(i. The above investment policy is the one which could have been achieved if q were perfectly observed by all parties and if a complete set of enforceable contracts specifying any investment policy could have been written. The following definition facilitates a discussion and comparison of various investment policies: Definition 1: An investment policy of investing in the risky project for all q>cj will be denoted as investment policy [il. An investment policy [G] produces the distribution of terminal cashflows displayed in Fig. 1 (given that q is uniformly distributed on [O,l].) Based on Fig. 1, and given risk-neutral pricing of terminal cashflows, the present value of an investment policy [
(3)
K. John et al. ! Journal of 3anking and Finance. 18 (1994)
307-323
313
Using Eq. (3) and the Pareto optimal investment policy [&j cha~cterized in (l), the highest present value V(g) achievable from the firm’s technology can be specified as follows:
3=v(~)=BI+~[1-~]2+~cl -(i2]
(4)
Clearly the investment policy [a], where 4 is given in (I), and the resulting value k’(4) specified in (4) forms a useful benchmark to measure the ~stortions caused by suboptimal financing packages. If a su~ptimal financing structure induced an investment policy [a, with present value V(g), then the value lost through suboptimal financing and resulting inefficient investment is P- V(@. It should be apparent that the cut-off level of 4, say @,which determines the investment policy [G] determines the riskiness of the distribution of terminal cashflows realized at t=2 (shown in Fig. 1). The lower the cut-off used, the more likely it is that the risky investment is undertaken and the riskier the distribution of terminal cashflows. From the terminal cashflow distribution in Fig. 1, for q1
When the bank is not a controlling bank and is holding on to debt of face value F >L, it is well known that the insiders have incentives to pursue investment policies which are riskier and less efficient than [G]. Proposition 1 collects some results on the investment policy of the firm when it is financed with some debt. (a) With debt of promised payment F>O, the manager will implement an investment policy [q(F)], where q(F) is given in Eq. (5): q(F)=4
when FGL
I-F =-.-.---. when L
(5)
=0 when F2.I. (b) When the debt is risky, i.e., F> L the manager implements an investment pohcy which is suboptimal and riskier than the Pareto optimal one, [Q].
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(c) In the range of F,L< F
resulting is strictly
1.
Two important insights follow from Proposition 1, (b) and (c). If the bank were to provide financing of I, partly through equity claims, then the required face value of debt needed by the firm will be lower and the implemented investment policy will be less risky than in the all debt case. Although the banks’s holding of equity suggests a riskier bank portfolio, this effect may be offset by the reduced riskiness of the firm’s implemented investment policy. In other words, the risk of the bank’s portfolio is affected by the structure of claims it holds in borrowing firms not only through the nature of the claims (debt us equity) but also through the riskiness of the induced investment choices made by the firm.
2.3.
The social planner’s (regulator’s)
objective
In the debate on the advisability of eliminating the separation between banking and commerce, several social goals may play a role. As mentioned in the introduction, our focus will be on: (1) the benefits of universal banking in improving firms investment efficiency, and (2) potential costs from increased risk to the banking sector. To be more specific let {a,F(or)} be a feasible financing package used by the bank, i.e., aE(cl,F) +B(cr,F)=I, where E( .) and B( .) are the prices of equity and bank debt, anticipating the investment policy [q(F(cc))] induced by such a financing package {a,F(cr)). We use V(a) to denote the total present value resulting from the investment policy [q(F(a))] and L?(U) to denote the variance of the terminal cashflow or asset risk, min{p,F}+cr(p-F)+, which accrues to the bank. The social objective S(N) is an increasing function of V(m) and a decreasing function of Q(a). If the maximal value of S is attained when a* = 0, then the current separation of commerce and banking is socially optimal. If it is attained when a* >O, then universal banking with bank equity ownership of a* is optimal. In Section 3 we will analyze the behavior of V(a) and @CC)when CYis increased from 0 to &=(I-- L)/V for two different scenarios of firm investment policy control by the bank. In the case of the non controlling bank, V(R) increases with cc,Odcc< B and Q(a) - asset risk decreases with a,Od c1< 8. Here the social objective is maximized at &> 0. In the case of the controlling bank it will be shown that V(g) increases with cr,O
K. John et al. / Journal of Banking and Finance I8 (1994) 307-323
Q(N). In this case cr*,O
degree
of bank
315
equity-
3. Efficiency, risk and universal banking In this section we will examine the investment efficiency and risk of the bank portfolio for different degrees of bank equity ownership in the borrowing firm. Intuitively it might be thought that the risk of a bank’s portfolio should increase with higher levels of bank equity holdings in the firm. This, however, ignores the effect of the debt-equity (capital) structure of financing claims on firm (the insiders’) incentives, which in turn, determines their investment project choice and its risk. The investment choice implemented will, in addition, depend on the degree of control exercised by the bank over the investment policy of the borrower firm. In the following sections we will characterize the relationships between ownership structure and efficiency of investment, and between ownership structure and the risk of the bank portfolio in two regimes: (1) firm insiders control investment policy and (2) the bank controls firm investments policy through its right to veto risky projects.
3.1. Firm-controlled
investment
In this section we extend the basic model of Section 2 to examine the scenario of investment under moral hazard and imperfect information. Corporate insiders are now assumed to privately observe 4, the quality of the risky investment, and to choose the investment (risky project or riskless project) in their own best interests. In this sub-section the bank is assumed to be a financier only, and claims are restricted to be debt of face value, F 2 0 and an ownership fraction a,Odcr< 1, of the firm’s equity. For any given value of F, the insiders choose an investment policy [q(F)] described in Proposition 1. Rational pricing of bonds as B(a,F) and equity as E(LY,F) take into account the investment policy [q(F)], characterized in (5), induced by {a,F(cr)}. A feasible financing mix {cr,F} satisfies the resource balance condition, B(c(,F) + c&(cl,F) = I
(6)
Since our focus is on the ‘social value’ of universal banking we will examine the investment efficiency achieved under different ownership levels of the firm by the bank and the resulting risk of the bank’s position {cc,F). For any a, we can characterize a level of promised payment on debt F, say F(a),
316
K. John et af. 1 Journal of Banking and Finance I8 ( 1994) 307-323
such that the resource balance Eq. (6) is satisfied. For the feasible financing package {@(IX)) we can denote the present value of total terminal cashflows obtained from the investment policy [q(F(cr))] as V(g); the variance of the bank’s total cashflows at t=2 can be denoted as Q(a). For a financing package {&,L) the Pareto optimal investment policy will be implemented (see Eq. (5)). Denote the value of terminal cashflows as P and the risk of the bank’s cash flows as 6. First, we wili prove a result about the level of debt required and the investment policy implemented if the ~nan~ing package does not have any (non-controlIing) equity ownership by the bank. Proposition 2: If I > L and a=O, the only feasible level of promised payment, F, equals (2Z- L). The investment policy implemented is CO], i.e., the risky project is always chosen. The resulting value, V(0) is (H f L)/2, and the variance of the bank’s position, Q(O), equals (I - L)2. Proof: First, note that F <:I will not satisfy the resource-balance condition, when c(= 0. For F> I, the investment policy implemented is [0] from Proposition 1. Given that the resulting terminal distribution is H with probability $ and L with probability $, straightforward computation yields F=(2Z--L), V=(H+L)/2 and 52=(1--L)‘.[7
Proposition 2 emphasizes the role of the implemented investment policy in determining the risk of the bank’s portfolio. Even though the bank holds no equity in the firm, the face value of debt needed to satisfy the resource balance condition is high (anticipating the risky investment policy that will be implemented). By substituting some of this debt with equity, the riskshifting incentives of the firm are curtailed resulting in a safer investment policy. The next proposition shows that it is possible that the reduced risk of the firm’s investment policy may make the risk of the bank portfolio lower even though it now holds an equity stake in the borrowing firm. Proposition 3: Again, consider I> L. With the financing package {&,LI where d=(Z- L)/e the Pareto optimal investment policy [G] is implemented, resulting in value @and bank risk b<(Z -L)2. Proof With F= L, the investment policy implemented is seen to be [G] from Eq. (5). Direct computation of the variance of the bank’s position, L+$(PL), (where P is the realized cashflow H, Z or L) shows that Q(k)=f(Z-L)*, where
Now, 6’>(H + L)/2 and (H-L) This in turn implies b<(Z-_)‘.a
<(H + L) can be shown to imply that f < 1.
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317
This proposition implies that by going to a financing package with an ownership fraction & and purely riskless debt (of promised payment L) the bank actually reduces the risk of its portfolio, compared to the financing of Proposition 2 with only debt and no equity ownership. Moreover, the efficiency of investment policy increases from [0] to [g] with attendant value increase from (H+ L)/2 to f? In fact, it can be shown that the efficiency and risk gains achieved as ~1increases from 0 to & is monotonic. P~o~o~~~~o~4: Consider the family of financing packages ja,F(a)),O< a< =B, where the extreme package (0,21--L) and (a&> were considered in Proposition 3. For a,O
As the bank’s equity ownership goes from 0 to 0.6 the firm’s debt level goes from 2 to 0. The firm’s value goes from lf to 13 and the risk of the bank portfolio goes from I to 0.56. The social objective is maximized at &=0.6, i.e., at 6074 of equity ownership in the firm by the bank. The above relationships are also displayed in graphs (Fig. 2) and (Fig. 3) along with the corresponding graphs for the case of bank-controlled investment discussed in the next sub-section (Section 3.2).
3.2. Bank-controlled investment In this sub-section we examine the case of the bank having some veto control over investment decisions by the firm. The role of the bank having control over the firm’s investment decisions is in the spirit of banking theory models which depict banks as delegated monitors or ‘main banks’ supplying funds to firms in a world of imperfect and asymmetric information. Several
318
K. John et af. / Journal of Banking and Finance 18 j1994) 307-323 Table 1 Firm-controlled c1
0
0.05 0.1
0.2 0.3 0.4 0.4784 0.48 0.49 0.5 0.55 0.57 0.6
investment
q(F) L.
1.9474 1.8889 1.75 1.5714 1.3333 0.81 0.7432 0.6266 0.5505 0.2629 OS582 0
(F)
f’CdF)I
Variance
0 0 0 0 0 0
1.5
1 1 1 1 1 1 0.7829 0.7318 0.6647 0.633 0.5703 0.5626 0.56
0.0868 0.1138 0.1573 0.1835 0.2693 0.2962 0.3333
1.5
1.5 1.5 is 1.5 1.5755 1.5944 1.6202 1.633 1.6605 1.6646 1.6667
This table displays the value of total terminal cash flows V(q(F)) and variance of bank asset portfolio for different values of bank ownership a, the debt level F which satisfies the resource balance condition (6) and the induced investment policy [q(F)].
Fraction of equity owned by bank
Fig. 2. Bank ownership and investment efficiency.
K. John et al. / Journal of Banking and Finance 18 (1994) 307-323
.-0
1
$ 2
0.8-
Y 5 D
0.6-
319
75 8 s s‘E
0.40.20 0
,,,..,.... ?.“’ ,,I.,,.“. .a’_’ ,,.,,,..... “’ ,,,_ ,.,_..... .““’ .,,(,, _...“.l....~‘u”’ _.“....... .““’ ,,,,_.,,,,,.,......... ..”,_,.((,,,, ,,_......_..-. I I I I 0.3 0.4 0.1 0.2 Fraction of equity owned by bank
-
Firm Control
Fig. 3. Bank ownership
I 0.5
0.6
.-.....‘....-..Bank Control
and bank portfolio
risk.
researchers (e.g., Fama, 1985) have argued that lending puts banks in the position of privileged quasi-insiders or informed lenders. In this position a bank may exercise both monitoring and control over the type of the projects (and their risk) chosen by the firm. In our model we capture the idea of the bank having some control over the investment decision by the following device. When the firm’s corporate insiders propose investment in a risky project after observing 4 at t= 1, the bank has the right to veto that project. In which case, the investment is then made in the riskless project (riskless bonds). Here the bank does obtain information about 4, the quality of the risky project. It vetoes the project if it is in its interest to do so given the structure the financing claims {cr,F} it holds in the firm. When the bank holds claims {CT@},its share of the terminal cashflows P( =H,I or L) equals min{F,P} + ctmax{P-F,O}, since the bank would veto the risky project when it is not in its interest for the firm to undertake it. We can characterize the investment policy [@I as the one which will be implemented when the bank has the veto power. Proposition 5: In the case of bank-controlled investment policy, when the bank holds claims {cr,F}, it will veto all risky projects with q
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I( John er nl. / Journaf of Banking and Finance 18 j1994) 307-323
Ffl--ct)+af-L
whenL
qc=F(l-a)+aH-L’ I-L *C=Fjl-n)+a&-i
(8)
when F>sl
The implemented investment policy is [q”]. Proa$ Holding project, iE
claims (a,F) the bank will refrain from vetoing a risky
where quantity (4)’ z max{0,4). N ow the cut-off probability qf is the lowest value of q which satisfies (9), as an equality. Solving for the relevant range of F we obtain Eq. (8). Since q” is always larger than q(F) (characterized in Eq. (5)), which is the cut-off used for proposals by corporate insiders, the bank’s vetoes are binding. Therefore, the implemented investment policy is [@].O Now that we have characterized the investment policy [q’] that will be implemented under bank-control, we can examine investment efficiency and bank asset risk for various feasible financing packages held by the bank. The procedure is similar to that followed in Section 3.1, although some of the results are different. The financing package (OJ) is a feasible one and a very conservative investment policy if implemented. The value of terminal cash flows is merely I (the investment being in the riskless asset for all values of 9) and the variance of the bank’s cash flow is zero. Although the risk is low, the loss in terminal value, ( P-Z), is very high. Similarly (12,L) is also a feasible ~nan~ing package. (Recall B= (I - L)/?). The investment policy implemented is [ii] with attendant value of Pand the variance of the bank’s portfolio is 6. Compared to the case above with financing package (0, I>, the investment efficiency has gone up from I to P but the bank risk also has gone up from zero to 6. Now there is a genuine return-risk trade-off from increasing the ownership structure of banks, since enhanced investment efficiency is attained at a cost of increased risk in the banking system. As before, our focus is on the social value of universal banking as reflected by firm investment efficiency and bank risk for various levels of the bank’s equity ownership in the borrowing firm. For any equity ownership fraction cr,OdccCL?, we can determine F(a) given by the resource balance condition (6) and the corresponding investment policy [q’] in (8). For all feasible financing packages (a,&‘(a)> we characterize the value of total terminal
1% John et al. / Journal of Banking and Finance 18 j1994/
307-323
321
Table 2 Bank-controlled
investment
a
F
0
1
1
1
0
0.05
0.9952 0.9812 0.9254 0.826 0.6667 0.4747 0.4416 0.4142 0.2341 0.148 0
0.9087 0.831 0.7016 0.5941 0.5 0.4309 0.4225 0.4142 0.3733 0.3573 0.3333
1.1701 1.2952 1.4633
0.005 0.0197 0.0764 0.1652 0.28 0.3862 0.400 1 0.4142 0.4862 0.5156 0.56
0.1 0.2 0.3 0.4 0.48 0.49 0.5 0.55 0.57 0.6
Vq’)
Variance
1.5647 1.625 1.6524 I.6547 1.6569 1.6643 1.6658 1.6667
This table displays the value of total terminal cashflows V(q’) and variance of bank asset portfolio for different values of bank ownership a, the debt level F which satisfies the resource-balance condition (6) and the induced investment policy [q’].
cashflows V(a) and the risk of bank portfolio Proposition 6 holds:
Q(E). It can be shown that
Proposition 6: Consider the family of financing packages {a,F(a))),Od cl<& where the extreme packages (0, 11 and {a, Lf were discussed above. For cr,Od cr<&,V(ol) is increasing in 01from V(O)=I to V(e)= l? Similarly, for a,0 < TV < B, 52(a) is increasing in cI from Q(O)= 0 to Q(B)= Sz> 0.
This proposition shows that the relationship between firm investment efficiency and bank equity ownership is a monotonically increasing one (as in the case of firm-controlled investment). However, the risk of the bank’s portfolio is increasing in bank equity ownership in the firm (opposite to the case when insiders in the firm controlled investment policy). Since the social objective function S(E) is increasing in V(g) but decreasing in L?(a) it is clear that increased bank ownership poses a real social welfare trade-off. The optimal level of bank ownership, a*, will be determined by the trade-off (value weights) implied in the social objective function, S(a). Example 2: In this example for the bank-controlled investment case, we use the same parameters, H = 3, L,= 0 and I = 1 as in example 1. Different levels of bank equity ownership a, 06 aGO.6, the corresponding level F(a) of debt (subject to resource balance condition (6)), resulting investment policy [qC(F,a)], value of total terminal cashflows V(a), and the variance of the bank’s terminal cashflows, Q(a) are all listed in Table 2.
As the ownership goes from 0 to.6, the debt level goes from I to 0. The
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K. John et al. / Journal of Banking and Finance 18 (1994) 307-323
firm’s value goes from 1 to 15 while, the risk of the bank portfolio increases from 0 to 0.56. These relationships are also displayed in Figs. 2 and 3 along with the corresponding case of firm-controlled investment discussed in the previous section (Section 3.1). In the case of bank-controlled investment, the value of c(, say LX*,which maximizes S(U), will not, in general, be equal to B, and it may be in the interior of [0, a].
4. Conclusion Several interrelated costs and benefits enter into the debate on the merits of eliminating the separation of commerce and banking. In this paper we have focused on two aspects. On the benefit side we examine how bank ownership of equity in firms may contribute to investment efficiency in an environment with private information and moral hazard. On the cost side we consider the asset risk to the banking system from holding both debt and equity claims in firms. A commonly raised concern is that equity ownership by banks in borrowing firms increases the risk of the bank portfolios and this will in turn impose increased potential costs on the Central Bank, the deposit insurance system and the payment system (the so-called federal safety net). The setting for our analysis was one of moral hazard in which the risk choices in investment policy made by corporate insiders were ‘private actions,’ and the financing of the representative firm was undertaken by a single bank. The social planner’s objective was modelled as being increasing in firm investment efficiency but decreasing in the risk (variance) of the bank’s asset portfolio. The structure of claims held by the bank on the firm (i.e., the bank’s asset structure) and the degree of control exercised by the bank over the firm’s investment policy were shown to be major determinants of the firm’s endogenous choice of investment risk. We studied two regimes of bank control of investments which were shown to affect firm investment efficiency and bank risk in important (and different) ways. In the case where insiders of the firm controlled investment, increases in a bank’s ownership of the borrowing firm’s equity increased investment efficiency and reduced the variance (risk) of the bank’s portfolio. The risk of increased equity ownership by the bank in the firm is offset by its effect in inducing a more conservative investment policy as a result of the firm having a lower leverage debt-equity ratio. Since both effects of increased equity ownership increase the value of the regulator’s objective, when insiders of the firm control investment policy, bank ownership of firm’s equity is unambiguously of social value. The results are more mixed in the case where the bank exercises more
control, i.e., the bank has a veto over the risky projects proposed by corporate management. In this case investment efficiency is increasing in the level of firm’s equity held by the bank. However, the ,asset risk of the bank portfolio also increases. As a result investment efficiency and risk have offsetting effects on the social objective function and the optimal bank equity ownership share is determined by this trade-off.
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