What Else Matters for Corporate Governance?: The Case of Bank Monitoring

Abstract

We address a crucial but underappreciated question: what else besides corporate law matters for corporate governance? We take the novel view that corporate governance must involve more than corporate law. Corporate scholars focus almost exclusively on corporate law mechanisms for controlling managerial agency costs. We contend, however, that contracting parties also attempt to control agency costs in their contracts with the firm. In particular, we hypothesize that banks, by monitoring firms in connection with their loans, enhance firm value for the benefit of shareholders.

We examine over one-thousand public firms for the period 1990-2004 to test the value of bank monitoring. Our approach builds on existing empirical scholarship on corporate governance, to which we add data on the presence of bank loans and their interactions with free cash flow, governance indices, and individual corporate governance provisions. We find evidence consistent with our hypothesis that bank monitoring improves firm value, especially where agency costs are high. Bank monitoring may provide an additional mechanism for corporate governance.

Our findings have important implications for both regulatory design and corporate governance. Bank monitoring may offer positive spillovers not previously considered in the crafting of regulation affecting bank lending, creditor rights, and the operation of loan and credit derivatives markets. Legal rules affecting bank lending or monitoring may indirectly and inadvertently affect firm value, a nontrivial consideration given the pervasiveness of bank debt among public companies. We identify a number of regulatory areas that may deserve new attention. Similarly, future empirical corporate governance research should account for the effects of bank governance, as well as investigate further its potential for improving firm value.

Keywords: corporate governance, corporate governance index, agency costs, entrenchment, bank monitoring, private debt, private lender, bank loan, free cash flow

JEL Classification: G30, G34, K22, G21