Monitored Finance, Liquidity and Institutional Investment Choice
Finance Dept. Working Paper No. 221
Posted: 10 Feb 1997
Date Written: May 1997
When a financial institution monitors firms that it finances, it acquires private information, creating a lemons problem when the institution needs financing. Since debt is less sensitive than equity to firm-specific information, holding debt improves the institution's liquidity. Debt's lower risk may also reduce monitoring incentives and any related lemons problems, increasing debt's attractiveness for firms with good initial prospects. For firms with poor initial prospects, a poorly-informed debtholder liquidates excessively; these firms prefer equity with reduced monitoring if feasible, and risky debt with intensive monitoring otherwise. The preference for debt finance is strongest for firms with limited access to public securities markets. Thus, debt-like claims should dominate the portfolios of institutions that specialize in providing monitored finance; among these institutions, those with greater liquidity needs should hold fewer monitored equity positions, make less risky loans, and monitor less intensively. These results are consistent with the general pattern of monitored finance and a number of cross-sectional institutional differences.
JEL Classification: G20, G32
Suggested Citation: Suggested Citation