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Insider control and the soft budget constraint: a simple theory
Economics Letters 61 (1998) 307–311
Insider control and the soft budget constraint: a simple theory David D. Li* Hoover Institution, Stanford, CA 94305 -6010, USA Received 30 March 1998; accepted 17 June 1998
Abstract Insider control of a firm is shown to be a cause of the soft budget constraint and it has many welfare consequences. The implication is that establishing effective corporate governance is a necessary measure to harden budget constraints. 1998 Elsevier Science S.A. All rights reserved. Keywords: Insider Control; Soft Budget Constraint; Property Rights; Control Rights; Corporate Governance JEL classification: D21; D23; L2; P31; P51
1. Introduction The soft budget constraint (SBC) (Kornai, 1980) refers to the expectation that a firm will be bailed out when facing financial difficulties. So far, there are two major groups of theories on causes of the SBC.1 Dewatripont and Maskin (1995) show that the SBC arises when creditors have limited information on the future return of an investment and cannot commit to terminating ex post profitable projects after the initial investment is made.2 Shleifer and Vishny (1994) argue that the SBC happens when politicians, who have non-profit objectives, obtain control rights of the enterprise. Complementing these theories, this paper shows that the SBC can also arise when insiders (managers) obtain critical control of the firm and enjoy substantial control benefits but do not have full claim rights to the liquidation value of the asset.3 Empirically, weak corporate governance leads to excessive insider control. In post-socialist economies, the retreat of government control plus the lack of large private investors leaves a vacuum of corporate control, giving insiders dominant control rights (see Aoki and Kim, 1995). For example, in a survey of Chinese state enterprises under reform, Li and Liang (forthcoming) find that over 80 percent of those profit losing enterprises issued bonuses in excess of the level regulated by the government and the excess bonuses accounted for an average of 35 percent of the losses. Therefore, a *Fax: 11-650-723-1687; e-mail: [email protected] 1 See Maskin (1996) for a survey of formal theories of the SBC. 2 Bai and Wang (1995) is a recent development in this direction. 3 The paper’s model is a variation of that of Li (1992), where the interpretation focuses on allocation of ownership rights. 0165-1765 / 98 / $ – see front matter 1998 Elsevier Science S.A. All rights reserved. PII: S0165-1765( 98 )00151-7
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D.D. Li / Economics Letters 61 (1998) 307 – 311
policy implication of the paper is that establishing corporate governance is a necessary measure in order to harden budget constraint.
2. The model There are two agents in the model: the insider (manager), M, and the outside financier or investor, F. M has no initial wealth and faces limited liability. Both are risk-neutral and have 0 discount rate. At time 1, M may propose a new project. A new project needs one unit of capital from F and one unit of labor from M. At time 2, either M or F decides whether to let the new project continue for one more period. At time 3, the surviving project is liquidated. To highlight the effects of insider control, we assume that capital is fully recoverable (i.e., not sunk), since otherwise the Dewatripont and Maskin (1995) effect comes into play. Profit is the same for a given project for all periods at u 2 r 2 w, where u is a random variable at time 1 and becomes known at time 2. Let ui (i 5 1 to 4) be the possible realization of u with qi being the corresponding probability and p i the profit level. At time 1, only M knows qi . Given that the paper is concerned with situations where market institutions are incomplete, we assume that M and F cannot sign enforceable contracts contingent upon u at time 1. M’s per-period payoff consists of wage w, shared profit s M p, and a benefit of control B. s M will be treated as exogenous, since our focus is on control rights arrangements. Given limited liability, s M is honored only if w 1 s M p $ 0. B is non-alienable and is lost for one period if at time 2 the project is terminated. Also, assume that other things being equal, M likes to propose a new project, i.e., his control benefit is slightly higher with a new rather than an old project. In addition, we make the following assumptions. Assumption 1: B $ w. Assumption 2: (1) p 1 5 u1 2 r 2 w . 0; (2) 2 w # p 2 5 u2 2 r 2 w , 0; (3) 2 B # p 3 5 u3 2 r 2 w , 2 w; (4) p 4 5 u4 2 r 2 w , 2 B. Assumption 3: w # 2 ]12 p 4 . Assumption 2 says that a social planner should terminate a project only in the case of u4 , taking into account the loss of B. Assumption 1 implies that B is relatively more important than w and Assumption 3 indicates that the worst profit is much worse than w. These two assumptions are not necessary but are useful to highlight the results.
3. Control rights and budget constraints We first consider a case where M has complete control rights of the firm so that at time 2, M decides whether to terminate the project. Depending on u, F may want to compensate M in order to terminate the project. Given our set-up, it is easy to show that a Coasian outcome arises, which maximizes the combined welfare. We have:
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Proposition 1 When M has complete control rights, an investment project will continue after time 2 unless u5u4 , when the project will be terminated after a proper compensation from F to M. At time 1, M decides whether to propose a new project by comparing his expected payoff with w1B (the payoff without proposing a new project). In order to calculate the expected payoff, we assume that M and F have equal bargaining power in a Nash bargaining when u4 is realized. We have the following predictions. Proposition 2 (1) When M obtains full control rights, unless q4 ;0, M proposes more projects than what is socially desirable; (2) when s M ,(w / 2p4 ), then a higher s M induces M to propose less socially undesirable projects; (3) when s M $(w / 2p4 ) and w $ 2 ]12 (p4 1 B) then an increase in s M makes M propose more socially undesirable projects. Part (1) is what Kornai (1980) calls the investment hunger. The intuition is that since M can use his control rights to shield himself from the downward risk, his proposal is reckless. Meanwhile, a higher s M may prompt M to propose less projects, since it worsens his default bargaining position in the case of u4 . But a higher s M also benefits M in the state of u1 . The net effect depends on the level of s M . We now consider the opposite case, i.e., F has complete control rights. Clearly at time 2, if u 5u1 , the project will continue. If u 5u2 , M has to bribe F (by using all or part of w) not to terminate the project. By Assumption 2, the end outcome of the Nash bargaining is for the project to continue. For the other two cases, w is not enough for M to bribe F so that the project will be terminated. Accordingly, we can calculate M’s payoff. In doing so, we make a simplifying assumption that M’s bargaining power is so small that he has to pay all of w to F in the case of u2 in order to avoid the termination decision.4 Also, note that at time 1, F always approves any proposed projects, since we assume that capital is recoverable. Therefore, we can show the following. Proposition 3 When F has complete control rights he approves all proposed projects. In addition, (1) a project continues after time 2 if u5u1 or u5u2 and it is terminated, otherwise; (2) unless q2 ; q3 ; q4 ;0, a less than socially desirable number of projects will be proposed by M; and, (3) a higher s M induces M to propose more projects. Finally, we can make a few comparisons between these two cases. The next corollary directly follows the previous propositions. Corollary 1 (1) The demand for investment is higher when M has complete control rights than when F has complete control rights, even though the two systems may have different profit shares. (2) Among all projects that survive beyond time 2, the average profitability is lower in an M control system than that in an F control system. (3) Among all invested projects, the average profitability is lower in an M control system than that in an F control system. We can also compare the overall social welfare in these two alternative cases. The trade-off is that the M control system makes better time 2 (ex post) decisions but the F control system may do a better job in ex ante decisions. During early stages of economic development, almost all projects are ex ante profitable and therefore the M control system can be very efficient. However, when there are many risky projects, the F control system is better. More precisely, we have: 4
It can be verified that without this technical assumption, the payoff structure is more complicated but all of the following results still hold qualitatively.
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D.D. Li / Economics Letters 61 (1998) 307 – 311
Proposition 4 (1) There exists an ] L, such that when q4 p4 #] L, the F control system is better than the M control case in terms of social welfare. In fact, in this case, no projects are approved in the M control system, while some socially efficient projects are proposed and approved in the F control system. (2) When q4 →0, q3 .0, and s M ,(w / 2p3 ) then the social welfare associated with the M control system is higher than that associated with F control arrangement.
4. Summary Complementing existing theories, the paper shows that insider control also leads to the SBC. It also shows that during the catching-up stage of economic development, an insider control arrangement may be more socially efficient than an outsider control system. In later stages of development, however, the opposite is true. A direct policy implication is that during reform, in order to harden budget constraints, it is necessary to establish effective corporate governance.
Acknowledgements I am grateful to Janos Kornai, Eric Maskin, Andrei Shleifer, and Martin Weitzman for their advice on an early version of this paper and to the R.R. Shaw Foundation for financial support. I would also like to thank Chongen Bai, Roger Gordon, Yingyi Qian, Thomas Rawski, Yijiang Wang, Wing Thye Woo, Huizhong Zhou, and seminar participants at Harvard University, University of Michigan, University of Missouri, and the 1994 Annual Meetings of the American Economic Association in Boston.
Appendix 1 Sketch of Proof of Proposition 2 Notice that when s M 50, the statement holds, given our assumption on B. Given the limited liability assumption (i.e. monetary payoff must not be negative), we need to deal with three non-trivial cases: 0,s M #(w / 2p 4 ); (w / 2p 4 ),s M #(w / 2p 3 ); (w / 2p 3 ),s M #(w / 2p 2 ); and s M $(w / 2p 2 ). The proofs in these cases are sufficiently similar so that we only show the first one. By the Nash bargaining assumption, it is easy to verify that M’s expected payoff is q1 (s M p 1 1w1B)1q2 (s M p 2 1 w1B)1q3 (s M p 3 1w1B)1q4 [s M p 4 1w1B2 ]12 (B 1p 4 )]. Thus, M proposes a project if q1 p 1 1 1 q2 p 2 1q3 p 3 $ ] 2s M q 4 (B 1p 4 )2q 4 p 4 . Comparing this with the social welfare criterion of investing in a project: q1 p 1 1q2 p 2 1q3 p 3 $q4 B, one can see that in this case, a more than socially optimal number of projects are proposed and a higher s M induces M to propose less projects. Sketch of the Proof of Proposition 3 Part (1) is already analyzed in the main text. As for parts (2) and (3), notice that M proposes a project only if q1 s M p 1 1q2 B 1q3 w1q4 w.w1B . Comparing this with the social welfare criterion in the previous proof, all the statements can be shown.
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Proof of Proposition 4 For part (1), notice that when q4 p 4 is very negative, given our limited liability and the Nash bargaining assumption, when M has complete control rights, F bears a large amount of expected loss, which eventually offsets his profit in the other states and forces him not to approve any projects. Meanwhile, in the F control system, the most profitable projects are always proposed and approved. For part (2), from the proof of part (1) of Proposition 2, when q4 50 and s M ,(w / 2p 3 ), M’s demand for capital is socially efficient. Also, it is easy to see that F’s decision to approve a project is the same as the social welfare criterion. There is no efficiency loss at all with the M control system. On the other hand, the F control system still closes the project when p5p 3 . This is efficiency losing. References Aoki, M., Kim, H. (Eds.), 1995. Corporate Governance in Transitional Economies: Insider Control and the Role of Banks. Washington, DC: The World Bank. Bai, C., Wang, Y., 1995. A Theory of the soft budget constraint. Department of economics working paper, Boston College. Maskin, E., 1996. Theories of the soft budget constraint. Japan and the World Economy 8, 125–133. Dewatripont, M., Maskin, E., 1995. Credit and efficiency in centralized and decentralized economies. Review of Economic Studies 62, 541–556. Kornai, J., 1980. Economics of Shortage. North-Holland, Amsterdam. Li, D., Liang, L., Forthcoming. Causes of the soft budget constraint: evidence on three explanations. Journal of Comparative Economics. Li, D., 1992. Essays on Ownership, Corporate Control and Privatization. Ph.D. Dissertation, Harvard University. Shleifer, A., Vishny, R., 1994. Politicians and firms. Quarterly Journal of Economics 109, 995–1026.
Insider control and the soft budget constraint: a simple theory David D. Li* Hoover Institution, Stanford, CA 94305 -6010, USA Received 30 March 1998; accepted 17 June 1998
Abstract Insider control of a firm is shown to be a cause of the soft budget constraint and it has many welfare consequences. The implication is that establishing effective corporate governance is a necessary measure to harden budget constraints. 1998 Elsevier Science S.A. All rights reserved. Keywords: Insider Control; Soft Budget Constraint; Property Rights; Control Rights; Corporate Governance JEL classification: D21; D23; L2; P31; P51
1. Introduction The soft budget constraint (SBC) (Kornai, 1980) refers to the expectation that a firm will be bailed out when facing financial difficulties. So far, there are two major groups of theories on causes of the SBC.1 Dewatripont and Maskin (1995) show that the SBC arises when creditors have limited information on the future return of an investment and cannot commit to terminating ex post profitable projects after the initial investment is made.2 Shleifer and Vishny (1994) argue that the SBC happens when politicians, who have non-profit objectives, obtain control rights of the enterprise. Complementing these theories, this paper shows that the SBC can also arise when insiders (managers) obtain critical control of the firm and enjoy substantial control benefits but do not have full claim rights to the liquidation value of the asset.3 Empirically, weak corporate governance leads to excessive insider control. In post-socialist economies, the retreat of government control plus the lack of large private investors leaves a vacuum of corporate control, giving insiders dominant control rights (see Aoki and Kim, 1995). For example, in a survey of Chinese state enterprises under reform, Li and Liang (forthcoming) find that over 80 percent of those profit losing enterprises issued bonuses in excess of the level regulated by the government and the excess bonuses accounted for an average of 35 percent of the losses. Therefore, a *Fax: 11-650-723-1687; e-mail: [email protected] 1 See Maskin (1996) for a survey of formal theories of the SBC. 2 Bai and Wang (1995) is a recent development in this direction. 3 The paper’s model is a variation of that of Li (1992), where the interpretation focuses on allocation of ownership rights. 0165-1765 / 98 / $ – see front matter 1998 Elsevier Science S.A. All rights reserved. PII: S0165-1765( 98 )00151-7
308
D.D. Li / Economics Letters 61 (1998) 307 – 311
policy implication of the paper is that establishing corporate governance is a necessary measure in order to harden budget constraint.
2. The model There are two agents in the model: the insider (manager), M, and the outside financier or investor, F. M has no initial wealth and faces limited liability. Both are risk-neutral and have 0 discount rate. At time 1, M may propose a new project. A new project needs one unit of capital from F and one unit of labor from M. At time 2, either M or F decides whether to let the new project continue for one more period. At time 3, the surviving project is liquidated. To highlight the effects of insider control, we assume that capital is fully recoverable (i.e., not sunk), since otherwise the Dewatripont and Maskin (1995) effect comes into play. Profit is the same for a given project for all periods at u 2 r 2 w, where u is a random variable at time 1 and becomes known at time 2. Let ui (i 5 1 to 4) be the possible realization of u with qi being the corresponding probability and p i the profit level. At time 1, only M knows qi . Given that the paper is concerned with situations where market institutions are incomplete, we assume that M and F cannot sign enforceable contracts contingent upon u at time 1. M’s per-period payoff consists of wage w, shared profit s M p, and a benefit of control B. s M will be treated as exogenous, since our focus is on control rights arrangements. Given limited liability, s M is honored only if w 1 s M p $ 0. B is non-alienable and is lost for one period if at time 2 the project is terminated. Also, assume that other things being equal, M likes to propose a new project, i.e., his control benefit is slightly higher with a new rather than an old project. In addition, we make the following assumptions. Assumption 1: B $ w. Assumption 2: (1) p 1 5 u1 2 r 2 w . 0; (2) 2 w # p 2 5 u2 2 r 2 w , 0; (3) 2 B # p 3 5 u3 2 r 2 w , 2 w; (4) p 4 5 u4 2 r 2 w , 2 B. Assumption 3: w # 2 ]12 p 4 . Assumption 2 says that a social planner should terminate a project only in the case of u4 , taking into account the loss of B. Assumption 1 implies that B is relatively more important than w and Assumption 3 indicates that the worst profit is much worse than w. These two assumptions are not necessary but are useful to highlight the results.
3. Control rights and budget constraints We first consider a case where M has complete control rights of the firm so that at time 2, M decides whether to terminate the project. Depending on u, F may want to compensate M in order to terminate the project. Given our set-up, it is easy to show that a Coasian outcome arises, which maximizes the combined welfare. We have:
D.D. Li / Economics Letters 61 (1998) 307 – 311
309
Proposition 1 When M has complete control rights, an investment project will continue after time 2 unless u5u4 , when the project will be terminated after a proper compensation from F to M. At time 1, M decides whether to propose a new project by comparing his expected payoff with w1B (the payoff without proposing a new project). In order to calculate the expected payoff, we assume that M and F have equal bargaining power in a Nash bargaining when u4 is realized. We have the following predictions. Proposition 2 (1) When M obtains full control rights, unless q4 ;0, M proposes more projects than what is socially desirable; (2) when s M ,(w / 2p4 ), then a higher s M induces M to propose less socially undesirable projects; (3) when s M $(w / 2p4 ) and w $ 2 ]12 (p4 1 B) then an increase in s M makes M propose more socially undesirable projects. Part (1) is what Kornai (1980) calls the investment hunger. The intuition is that since M can use his control rights to shield himself from the downward risk, his proposal is reckless. Meanwhile, a higher s M may prompt M to propose less projects, since it worsens his default bargaining position in the case of u4 . But a higher s M also benefits M in the state of u1 . The net effect depends on the level of s M . We now consider the opposite case, i.e., F has complete control rights. Clearly at time 2, if u 5u1 , the project will continue. If u 5u2 , M has to bribe F (by using all or part of w) not to terminate the project. By Assumption 2, the end outcome of the Nash bargaining is for the project to continue. For the other two cases, w is not enough for M to bribe F so that the project will be terminated. Accordingly, we can calculate M’s payoff. In doing so, we make a simplifying assumption that M’s bargaining power is so small that he has to pay all of w to F in the case of u2 in order to avoid the termination decision.4 Also, note that at time 1, F always approves any proposed projects, since we assume that capital is recoverable. Therefore, we can show the following. Proposition 3 When F has complete control rights he approves all proposed projects. In addition, (1) a project continues after time 2 if u5u1 or u5u2 and it is terminated, otherwise; (2) unless q2 ; q3 ; q4 ;0, a less than socially desirable number of projects will be proposed by M; and, (3) a higher s M induces M to propose more projects. Finally, we can make a few comparisons between these two cases. The next corollary directly follows the previous propositions. Corollary 1 (1) The demand for investment is higher when M has complete control rights than when F has complete control rights, even though the two systems may have different profit shares. (2) Among all projects that survive beyond time 2, the average profitability is lower in an M control system than that in an F control system. (3) Among all invested projects, the average profitability is lower in an M control system than that in an F control system. We can also compare the overall social welfare in these two alternative cases. The trade-off is that the M control system makes better time 2 (ex post) decisions but the F control system may do a better job in ex ante decisions. During early stages of economic development, almost all projects are ex ante profitable and therefore the M control system can be very efficient. However, when there are many risky projects, the F control system is better. More precisely, we have: 4
It can be verified that without this technical assumption, the payoff structure is more complicated but all of the following results still hold qualitatively.
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D.D. Li / Economics Letters 61 (1998) 307 – 311
Proposition 4 (1) There exists an ] L, such that when q4 p4 #] L, the F control system is better than the M control case in terms of social welfare. In fact, in this case, no projects are approved in the M control system, while some socially efficient projects are proposed and approved in the F control system. (2) When q4 →0, q3 .0, and s M ,(w / 2p3 ) then the social welfare associated with the M control system is higher than that associated with F control arrangement.
4. Summary Complementing existing theories, the paper shows that insider control also leads to the SBC. It also shows that during the catching-up stage of economic development, an insider control arrangement may be more socially efficient than an outsider control system. In later stages of development, however, the opposite is true. A direct policy implication is that during reform, in order to harden budget constraints, it is necessary to establish effective corporate governance.
Acknowledgements I am grateful to Janos Kornai, Eric Maskin, Andrei Shleifer, and Martin Weitzman for their advice on an early version of this paper and to the R.R. Shaw Foundation for financial support. I would also like to thank Chongen Bai, Roger Gordon, Yingyi Qian, Thomas Rawski, Yijiang Wang, Wing Thye Woo, Huizhong Zhou, and seminar participants at Harvard University, University of Michigan, University of Missouri, and the 1994 Annual Meetings of the American Economic Association in Boston.
Appendix 1 Sketch of Proof of Proposition 2 Notice that when s M 50, the statement holds, given our assumption on B. Given the limited liability assumption (i.e. monetary payoff must not be negative), we need to deal with three non-trivial cases: 0,s M #(w / 2p 4 ); (w / 2p 4 ),s M #(w / 2p 3 ); (w / 2p 3 ),s M #(w / 2p 2 ); and s M $(w / 2p 2 ). The proofs in these cases are sufficiently similar so that we only show the first one. By the Nash bargaining assumption, it is easy to verify that M’s expected payoff is q1 (s M p 1 1w1B)1q2 (s M p 2 1 w1B)1q3 (s M p 3 1w1B)1q4 [s M p 4 1w1B2 ]12 (B 1p 4 )]. Thus, M proposes a project if q1 p 1 1 1 q2 p 2 1q3 p 3 $ ] 2s M q 4 (B 1p 4 )2q 4 p 4 . Comparing this with the social welfare criterion of investing in a project: q1 p 1 1q2 p 2 1q3 p 3 $q4 B, one can see that in this case, a more than socially optimal number of projects are proposed and a higher s M induces M to propose less projects. Sketch of the Proof of Proposition 3 Part (1) is already analyzed in the main text. As for parts (2) and (3), notice that M proposes a project only if q1 s M p 1 1q2 B 1q3 w1q4 w.w1B . Comparing this with the social welfare criterion in the previous proof, all the statements can be shown.
D.D. Li / Economics Letters 61 (1998) 307 – 311
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Proof of Proposition 4 For part (1), notice that when q4 p 4 is very negative, given our limited liability and the Nash bargaining assumption, when M has complete control rights, F bears a large amount of expected loss, which eventually offsets his profit in the other states and forces him not to approve any projects. Meanwhile, in the F control system, the most profitable projects are always proposed and approved. For part (2), from the proof of part (1) of Proposition 2, when q4 50 and s M ,(w / 2p 3 ), M’s demand for capital is socially efficient. Also, it is easy to see that F’s decision to approve a project is the same as the social welfare criterion. There is no efficiency loss at all with the M control system. On the other hand, the F control system still closes the project when p5p 3 . This is efficiency losing. References Aoki, M., Kim, H. (Eds.), 1995. Corporate Governance in Transitional Economies: Insider Control and the Role of Banks. Washington, DC: The World Bank. Bai, C., Wang, Y., 1995. A Theory of the soft budget constraint. Department of economics working paper, Boston College. Maskin, E., 1996. Theories of the soft budget constraint. Japan and the World Economy 8, 125–133. Dewatripont, M., Maskin, E., 1995. Credit and efficiency in centralized and decentralized economies. Review of Economic Studies 62, 541–556. Kornai, J., 1980. Economics of Shortage. North-Holland, Amsterdam. Li, D., Liang, L., Forthcoming. Causes of the soft budget constraint: evidence on three explanations. Journal of Comparative Economics. Li, D., 1992. Essays on Ownership, Corporate Control and Privatization. Ph.D. Dissertation, Harvard University. Shleifer, A., Vishny, R., 1994. Politicians and firms. Quarterly Journal of Economics 109, 995–1026.