Should Banks Own Equity Stakes in Their Borrowers?

42 Pages Posted: 22 Dec 2001

See all articles by Jan Mahrt-Smith

Jan Mahrt-Smith

University of Toronto - Rotman School of Management

Date Written: November 2001

Abstract

This paper develops a model to examine the question whether banks should hold a share of their borrowing firms' equity. Without the equity participation, the bank uses its informational advantage over other sources of finance (e.g. competing banks) to extract profits from the client firm whenever the firm needs additional investment funds. This, in turn, reduces the incentives of the borrowing firm to generate profits - an effect pointed out by Rajan (1992). Yet, this paper shows that even a small, minority equity stake held by the bank significantly reduces the propensity of the bank to extract profits, which then improves the incentives of the firm. This benefit of bank equity participation is related to firm characteristics, such as size, growth, capital needs, as well as banking sector competition and the quality of the prevailing financial disclosure practices in the economy. These relationships are consistent with existing empirical observations on firm-bank relationships in various countries. The paper addresses, from a corporate finance perspective, the current debate about whether banks should be allowed to own equity stakes, and if yes how large these should be.

Keywords: Ownership Structure, Corporate Control, Capital Structure, Banks, Banking Regulation

JEL Classification: G30, G32

Suggested Citation

Mahrt-Smith, Jan, Should Banks Own Equity Stakes in Their Borrowers? (November 2001). Available at SSRN: https://ssrn.com/abstract=291023 or http://dx.doi.org/10.2139/ssrn.291023

Jan Mahrt-Smith (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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