Should Banks Own Equity Stakes in Their Borrowers?

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