Bankers on boards as corporate governance mechanis

Authors: Agnieszka SlomkaGolebiowska

Publish Date: 2012/11/09

Volume: 18, Issue: 4, Pages: 1019-1040

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Abstract

This paper examines whether a bank exercises a monitoring role when a banker is represented on a firm’s board Bank monitoring reduces information asymmetries and hence lessens firm’s financial constraints—phenomenon frequently measured by investmentcash flow sensitivity in the sample of all nonfinancial companies listed during 1999–2002 on the Polish stock exchange I find that firms with a banker on the board rely more heavily on bank loans than on internal capital in their investment activities In contrast firms with no banker on the board finance to a larger extent their investment with internal capital than with credit However firms with the banklender representation on the board are almost as much financially constrained as firms without a banklender representative on the board Hence the presence of bankers on boards is not associated with bank monitoring They rather promote their employer’s business The findings show that investment of firms with a banker on the board is less sensitive to cash flow than investment of firms without bank representatives on the board This result suggests that bankers on the board provide financial expertise that help those firm to reduce financial constraintsWhen a transition process began in postcommunist economies in Central and Eastern Europe in the early 90s the state had withdrawn from corporate governance and a gap was revealed Since then corporate governance structures that are typical of a market economy have been slowly emerging Initially banks were expected to play a more important role as the banking sector was far more developed than capital market The latter was arising from scratch as well as institutions that support it After almost two decades since the transition started bank credit is far more significant source of external corporate financing compared to capital marketBanks as a significant provider of firm’s external capital want to obtain the returns on their investments The power of creditors comes from bankruptcy proceedings when they take control over debtor and its assets that served as collateral if the firm is not capable to repay the loan Collaterals and threat of bankruptcy may be regarded as passive modes of bank monitoring Banks may also actively control indebted firms and their investment decisions through relationship banking or sitting on the firm’s board Additionally in many countries banks are entitled to hold equity as well as debt of the firms they invest in or alternatively vote the equity of other investors Hence they have various possibilities to induce debtor’s managers to use credit according to the terms of contract Bank monitoring enables banks to gather inside information about a firm that are not accessible to other stakeholders The closer relationship with their corporate clients banks maintain the more successful they are in reducing information asymmetries between themselves and borrowers By reducing information asymmetries banks are able to lessen firm’s financial constraintsInformation asymmetries are central to the role of banks in corporate governance Akerlof 1970 Stiglitz and Weiss 1981 as they hinder access to external financing even in market equilibrium and hence lead to credit rationing Then firm investment depends on availability of internal capital Information asymmetries problem makes the cost of external financing higher than internal one In consequence firm’s managers always prefer less expensive internal capital to external one Myers and Majluf 1984 Diamond 1984 argues that close relationship with a bankcreditor is capable of lessening information asymmetries thus benefiting not only lender but also borrower through reducing both credit rationing and the cost of external financing Others indicate that close relationship with banks may generate lender’s rent extraction from the borrower because the latter is informationally captured by the former and hence not necessarily bring about the previously envisaged reduction in credit constraints for borrowers Sharpe 1990 Rajan 1992 Kracaw and Zenner 1998 The empirical evidence is scarce and conflicting for Japan Weinstein and Yafeh 1998 and for Germany Elsas and Krahnen 1998The aim of the study is to examine whether banks in Poland exercise monitoring role when a banker is represented on the firm’s board and hence firms are less financially constrained in their investment decisions Empirical literature confirms that credit contract allows for an efficient monitoring of corporate debtors through reducing information asymmetries Firms that maintain a close bank relationship tend to be less financially constrained in their business activities than firms without such ties For example Hoshi et al 1991 find that large Japanese corporations that have close financial ties to large banks that serve as their primary source of external finance face lesser financial constraints than firms without such a relationship with banks Using data on the same group of firms for a later period of time when liberalization of financial markets in Japan occurred McGuire 2003 shows that difference in financial constraints between the two groups of firms is much smaller as access to other than bank loans sources of external financing in particular bonds becomes available Van Ees and Garretsen 1994 for Dutch large companies as well as Elston 1996 and Harm 1996 reveal similar results for German large corporations According to Houston and James 2001 bankdependent firms in the US are less financially constrained in their investment activities than other firms that have credit relationship with a number of banks or are using bond financing The difference between those two groups of firms is significant when firms make relatively small investment 25  of their capital stock The access to bank financing for US firms depends on the size of planned investment and hence the mode of corporate governance depends for the level of investment outlays That is a consequence of legal solutions binding in the US such as equitable subordination and lender liability limit Their findings suggest that the role of banks in corporate control is determined very much by the institutional settings in particular regulatory regimeOver the last 20 years of the transition from a centrally planned to a market economy Poland reached a great progress in creating institutional conditions for banks’ involvement in corporate control However there is little empirical evidence of the bank monitoring Most studies were conducted for developed countries Few papers are available on emerging markets mostly Korea Ferri et al 2001 Bae et al 2002 Kim et al 2002 This study is the first attempt to address the issue for a transition country The reminder of this paper is organized as follows Section two preceded by introduction reviews why bankers are on the boards and whether their presence leads to lessening firm’s financial constraints In the third section the relevant institutional environment with regard to bankfirm relation in Poland as well as methodology and data are explained Fourth section discusses empirical results and selectivity bias In the last one conclusions and future research agenda are presentedRecent literature has suggested that the presence of bankers the board brings several benefits for firms Kroszner and Strahan 2001 Byrd and Mizruchi 2005 Dittmann et al 2009 First bankers may provide financial or investment expertise in particular if a bank acquired specific knowledge through lending to many firms from a certain industry Mace 1971 Lorsch and MacIver 1989 Number of studies provide empirical evidence Ramirez 1995 Morck and Nakamura 1999 Byrd and Mizruchi 2005 Ciamarra 2006 Dittmann et al 2009Second a close bank relationship formalized through board representation can play a certification role enabling firms to secure financing from other external sources both creditors as well as equity holders Fama 1985 Kracaw and Zenner 1998 Some studies show that firms with bankers on the board are more leveraged Booth and Deli 1999 also due to the fact that banks sell more debts to firms where they are represented Dittmann et al 2009

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