Managerial Protections, Capital Structure, and Investment: Theory and Evidence

Abstract

We introduce a model to illustrate three channels by which managerial protections affect how managers choose a firm’s capital structure and level of investment. First, protections can intensify the incentive for managers to increase their equity share, resulting in excessive debt financing. Second, protections reinforce the incentive for managers to avoid liquidation, leading to reduced investment. Third, an important policy implication of the model is that policies that constrain firm debt ratios, such as stress testing for bank holding companies, can counterintuitively stimulate investment for firms with protections. We find that these results are consistent with patterns in the data.

Keywords: Managerial protections, Stress testing, Capital structure, Ownership structure, Investment, Banking

JEL Classification: D24, G32