does banks´ corporate control benefit firms? evidence from us banks´ corporate control over...

Does banks´ corporate control benefit firms?Does banks´ corporate control benefit firms?Evidence from US banks´ corporate control over firms´ voting rightsEvidence from US banks´ corporate control over firms´ voting rights

João A.C. SantosFederal Reserve Bank of New York

Kristin E. WilsonHarvard Business School

The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

MotivationMotivation

• Jensen and Meckling (1976): shareholders have an incentive to increase risk to appropriate wealth from debtholders.

• Debtholders can protect themselves by adding covenants, but this is costly.

• Banks can eliminate free riding problems and reduce monitoring costs by acting as delegated monitors, but they will still likely charge a premium for the cost of borrower’s moral hazard

• One way to further lower the agency costs of debt is for the bank to hold an equity stake in the borrower.

• As a shareholder, the bank is entitled to a share of the firm’s profits and becomes less exposed to risk-shifting policies.

Motivation (cont.)Motivation (cont.)

• As a shareholder, the bank can also influence the borrower above and beyond its influence as a lender.

• The bank could use this influence to limit controlling shareholders’ ability to undertake suboptimal investment projects.

• The effects of banks’ corporate control may not be entirely positive -- banks could use it to “pressure” firms to borrow at uncompetitive rates.

• A study of the effect of a bank’s corporate control over its borrowers should determine which of these theories holds true.

• This is not an easy task: – It is difficult to disentangle the effects of corporate control from the effects

associated with the cash flow rights.– It is difficult to define a clean measure of banks’ corporate control.

Motivation (cont.)Motivation (cont.)

• We overcome these difficulties by considering the voting rights US banks control in connection with their trust investments.

• These investments “unbundle” the control rights from the cash flow rights of the firm’s stock; thus trust voting rights are a “clean” measure of banks’ corporate control

• Trust business is an important source of voting rights for US banks: the largest 100 banks controlled in 2000 on average 10% of the voting rights of S&P 500 firms (Santos and Rumble 2005)

• We build on the unique aspects of banks’ trust business to investigate the effect of banks’ corporate control.

• We investigate whether there is a reduction in the interest rates and in the incidence of covenants on the loans that banks extend to firms in which they have a voting stake.

Related literatureRelated literature

1. Studies of the value of stock voting rights. – Lease, McConnell, and Mikkelson (1983, 1984), De Angelo and DeAngelo

(1985) and Zingales (1995), compare the prices of shares with identical dividend rights, but differential voting rights.

– Chang and Mayers (1992), Gordon and Pound (1990), Dhillon and Ramirez (1994) and Chaplinsky and Niehaus (1994), look at stock market reaction to firms’ announcement of ESOPs.

– La Porta et al. (2002) and Claessens et al. (2002) rely on pyramid structures and crossholdings to identify a measure of control of large shareholders.

2. Studies of the effects of banks´ equity stakes in firms:– Investigate the effects on firms´ accounting interest expenses, leverage, credit

availability, performance, and ability to recover from distress.– Rely on data from Germany or Japan (exception James 1995).

– Do not attempt to separate the efffects of cash rights from voting rights

(exception Gorton and Schmid 1998).

Banks’ trust businessBanks’ trust business

• Bank trust services range from depository services to the selection of investments and the exercise of voting rights.

• When trust settlors or pension-plan sponsors give banks investment discretion, banks are required to select the investments within the confinements of the federal and state law.

• When banks are granted authority to vote trust shares, they need to exercise this authority within the confinements of the federal and state trust laws, and the terms of the trust instrument.

• Trust instruments usually confer the power to vote shares through standardized “boiler plate” language:

“The Trustee shall have power in its discretion to exercise all voting rights with

respect to any investment held in Trust Fund”.

Is trust voting a source of “power”?Is trust voting a source of “power”?• Do banks use their trust voting rights to exert corporate

influence or do they follow the “Wall Street Rule”? • The information available suggests that trust voting rights are a

potentially important source of corporate control for banks. – Deutsch Bank involvement in Hewlett-Packard acquisition of Compact– SEC survey of the trust business of large banks found that 57% of them

voted against management at least once during 1967-1969– The voting polices of banks

METHODOLOGY: HYPOTHESESMETHODOLOGY: HYPOTHESES

If banks´ voting rights in borrowers are important at reducing the agency costs of debt then, ceteris paribus, banks will:

a) charge lower interest rates on loans to firms in which they have a voting stake.

b) impose fewer restrictive covenants on loans to firms in which they have a voting stake

METHODOLOGY: MODELMETHODOLOGY: MODEL

LOANSPREAD = c + a LVOTSTAKE + Firm controls + Loan controls + ε

LOANSPREAD: loan’s spread over Libor at issue dateLVOTSTAKE: Log (1 + the bank´s voting stake in the borrwer)

Hypothesis 1: a < 0

Prob (Loan covenant) = c + β LVOTSTAKE + Firm controls + Loan controls + ε

Loan covenant: collateral, dividend restrcitions, guarantorLVOTSTAKE: Log (1 + the bank´s voting tsake in the borrwer)

Hypothesis 2: β < 0

METHODOLOGY: MODEL (cont.)METHODOLOGY: MODEL (cont.)

• FIRM CONTROLS:– AGE– ASSETS– TANGIBLES– R&D– ADVERTISING– MKTBOOK – PROFMARGIN – INTCOVERAGE – LEVERAGE – EARNVOL– STOCKVOL

METHODOLOGYMETHODOLOGY: MODEL (cont.): MODEL (cont.)

• LOAN CONTROLS:– Loan purpose and credit-contract type dummies

– LOANAMT

– DIVRESTRICT

– SENIOR

– SECURED

– RENEWAL

– GUARANTOR

– LENDERS

– SYNDICATED

– MATURITY

DATADATA

1. LPC’s Dealscan database2. SEC 13f Forms3. Compustat4. SDC’s Domestic New Bond Issuances database5. CRSP’s stock prices database6. Stock-Watson recession indexes

Banks´ voting stakesBanks´ voting stakes

SampleSample

-0.92.21.3INSVOTSTAKE

-0.030.050.02EARNVOL

0.32.02.3MKTBOOK

0.060.630.69TANGIBLES

-0.010.340.33LEVERAGE

27.010.937.9SALES

12.016.928.9AGE

-112.3260.9148.5LOANSPREAD

00.35VOTSTAKE

DifferenceBorrowers without

bank vot stakeBorrowers with bank

voting stakeVARIABLES

0.20.20.4RLENDING

Sample (cont.)Sample (cont.)

-0.43.22.8MATURITY

5.0611LENDERS

0.080.900.98SYNDICATED

-0.010.070.06GUARANTOR

-0.20.30.1SECURED

00.990.99SENIOR

-0.20.60.4DIVRESTRICT

1.71.02.7LOANAMT

DifferenceBorrowers without

bank vot stakeBorrowers with bank

voting stakeVARIABLES

Loan spreads and banks´ voting stakesLoan spreads and banks´ voting stakes

Model 1

LVOTSTAKE -128.0

(0.000)

Firm controls out

Loan controls out

Bank dummies out

R-squared 0.044


Model 1 Model 2

LVOTSTAKE -128.0

(0.000)

-46.6

(0.000)

Firm controls out in

Loan controls out out

Bank dummies out out

R-squared 0.044 0.435


Model 1 Model 2 Model 3

LVOTSTAKE -128.0

(0.000)

-46.6

(0.000)

-21.4

(0.000)

Firm controls out in in

Loan controls out out in

Bank dummies out out out

R-squared 0.044 0.435 0.558


Model 1 Model 2 Model 3 Model 4

LVOTSTAKE -128.0

(0.000)

-46.6

(0.000)

-21.4

(0.000)

-17.7

(0.001)

Firm controls out in in in

Loan controls out out in in

Bank dummies out out out in

R-squared 0.044 0.435 0.558 0.565

Robustness checksRobustness checks

• Results are robust to:– Lending relationships and firms’ access to bond market– Additional controls for risk:

• Stock price volatility;• Level of LIBOR.

– Membership in S&P500 index and in NYSE index.– Voting stakes of large shareholders:

• Voting stake of insiders;• Voting stake of institutional shareholders.

• Some loan deals have multiple facilities. Rerun tests using one facility per deal (3,533 observations); again, results unchanged.

• Could argue different pricing for different loan types. Rerun tests on credit lines only (72% of sample); again, results unchanged.

Controlling for banks´ selection of trust investmentsControlling for banks´ selection of trust investments

• We have treated banks´ voting stakes as exogenous. • Given banks´ equity investments, whether or not they gain

control over the voting rights is usually a decision of trust clients.• However, investment decisions are usually the responsibility of

banks not of their trust clients.• Is the interest rate discount the result of these investments or of

the voting rights?• Take advantage of the fact that not all investments give banks

voting rights to investigate this concern• We do two tests:

– Test 1: Add a dummy variable which equals 1 if the bank has a trust investment in the borrower

– Test 2: Add a variable which equals banks´ equity stakes in borrowers in which they have a trust investment but gained no voting rights as a result

Controlling for banks´ selection of investments (cont.)Controlling for banks´ selection of investments (cont.)

Model 1

LVOTSTAKE -17.7

(0.001)

EINVESTMENT

LNONVOTSTAKE

Firm controls in

Loan controls in

Bank dummies in

R-squared 0.565


Model 1 Model 2

LVOTSTAKE -17.7

(0.001)

-10.8

(0.046)

EINVESTMENT -9.6

(0.052)

LNONVOTSTAKE

Firm controls in in

Loan controls in in

Bank dummies in in

R-squared 0.565 0.572


Model 1 Model 2 Model 3

LVOTSTAKE -17.7

(0.001)

-10.8

(0.046)

-16.8

(0.001)

EINVESTMENT -9.6

(0.052)

LNONVOTSTAKE 45.9

(0.214)

Firm controls in in in

Loan controls in in in

Bank dummies in in in

R-squared 0.565 0.572 0.572

Banks´ voting stakes and loan covenantsBanks´ voting stakes and loan covenants

• Question: Are banks less likely to impose covenants on loans to firms in which they have a voting stake?

• Covenants that we investigate:

– The bank demands collateral

– The bank imposes dividend restrictions

– The bank demands a guarantor

Banks´ voting stakes and likelihood of loan Banks´ voting stakes and likelihood of loan covenantscovenants

Collateral required

LVOTSTAKE -0.3

(0.066)

EINVESTMENT -0.01

(0.871)

FIRM CONTROLS

in

LOAN CONTROLS

in

Pseudo R2 0.152


Collateral required

Div restrictions imposed

LVOTSTAKE -0.3

(0.066)

-0.4

(0.005)

EINVESTMENT -0.01

(0.871)

0.1

(0.266)

FIRM CONTROLS

in in

LOAN CONTROLS

in in

Pseudo R2 0.152 0.192


Collateral required

Div restrictions imposed

Gurarantor demanded

LVOTSTAKE -0.3

(0.066)

-0.4

(0.005)

-0.3

(0.188)

EINVESTMENT -0.01

(0.871)

0.1

(0.266)

0.1

(0.463)

FIRM CONTROLS

in in in

LOAN CONTROLS

in in in

Pseudo R2 0.152 0.192 0.078

Final remarksFinal remarks• Trust equity investments separate a stock’s cash rights from its

voting rights, giving the former to trust beneficiaries and placing the latter (sometimes) under banks’ control.

• We considered these aspects of the trust business to investigate the effects of banks’ corporate control over their borrowers.

• Our findings suggest that the influence banks can exercise in connection with their voting rights is valuable at reducing the agency costs of debt.

• Our results show a new source of value of voting rights.• They are also novel for the United States and raise questions

about the often-made claim that banking is separate from commerce in the United States.

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