# Presentation: 665090

##  Banking Relationships and Conflicts of InterestWook  SohnKDI School of Public Policy and ManagementMBA ProgramSeoul, Korea FDIC/JFSR Conference

## Research Questions 

- Highlight conflicts of interest in banking relationships.
- Key feature is _pre-existing relationships_ (or financial claims) between banks and borrowers before the banks’ lending decisions.
- Approach
- Part  1: Loan announcement effect in the stock
-                         market.  (empirical investigation)
- Part 2: Loan announcement effect in the stock
-                         market.  (theory)
- Part 3: Banks’ lending decisions (empirical).

## Event Description

|    Closed Banks |
| --- |
|                 C1 |
| C2 |
| C3 |
| C4 |
| C5 |

| Acquiring Banks |
| --- |
| A1 |
| A2 |
| A3 |
| A4 |
| A5 |

-        Prior Relationship
-    (Type P)

-     No Prior
-  Relationship
-    (Type N)

- 16 Other Banks

*Event Description*

- _Borrowing firms_

## Features of the Event

- _Exogenous_ selection and matching and the transfer of loans in their entirety.
- _No personnel_ were transferred from the closed banks to the acquiring banks (purchase and assumption).
- _Distinctions_ between the closed banks and the acquiring banks.
-         - BIS ratios: 5.32% vs. 9.64%
-           - Non-performing loans: 9.08% vs. 3.01%
-           - Market shares: 6.95% vs. 30.96%
- _Firms’ pre-existing relationships_ with the acquiring banks are identified.

## Event Description

|    Closed Banks |
| --- |
|                 C1 |
| C2 |
| C3 |
| C4 |
| C5 |

| Acquiring Banks |
| --- |
| A1 |
| A2 |
| A3 |
| A4 |
| A5 |

-        Prior Relationship
-    (Type P)

-     No Prior
-  Relationship
-    (Type N)

- 16 Other Banks

*Event Description*

- _Borrowing firms_

## Estimation of CARs

| CARs |     Mean          | Median [pos./neg.] |
| --- | --- | --- |
| (-7,-2) | -5.79**       (-2.48) | -4.39 [37/81]*** |
| (-1,+1) | -4.85**       (-2.94) | -7.85 [32/86]*** |
| (+2,+5) | -8.81***     (-4.62) | -8.31 [24/94]*** |
| (-7,+5) | -19.45***     (-5.65) | -20.56 [22/96]*** |
| (+6,+51) | 22.39***      (3.46) | 27.09 [74/44]*** |
| (-1,+51) | 8.73            (1.26) |     10.92 [65/53]* |

## Event Description

|    Closed Banks |
| --- |
|                 C1 |
| C2 |
| C3 |
| C4 |
| C5 |

| Acquiring Banks |
| --- |
| A1 |
| A2 |
| A3 |
| A4 |
| A5 |

-        Prior Relationship
-    (Type P)

-     No Prior
-  Relationship
-    (Type N)

- 16 Other Banks

*Event Description*

- _Borrowing firms_

## CARs for subsample 

|  |     Prior Relationship |  |  |  |
| --- | --- | --- | --- | --- |
| CARs |       0 
(Type N) | (0,1)
(mixed type) |        1 
(Type P) |                               t test |
| N | 45 | 28 | 45 |  |
|  (-1,+1) | -5.62 | -7.10 | -2.68 | 1.61 |
| (-1,+51) | 13.26 | 11.29 | 2.62 | -1.28 |

## Explanatory Variables

| Bank-firm relationship   | Exposure to  event | Firm-specific characteristics | Firm ownership | Bank-pair dummy |
| --- | --- | --- | --- | --- |
|  Prior rela-
   tionship
 Locational 
   advantage
 Main   
   creditor   
   bank |  #Closed 
   banks /
   #Lending 
   banks
Loan_closed 
  / Loan_all 
   banks
Collateralized 
   loan_closed 
   banks |  Age
 Size (asset)
 Sales 
    growth
 Profit / 
    interest
 Bond  
    finance
 Equity 
    finance
 Loan finance |  Chaebol 
    firm
 Proportion 
    of largest
    shareholder
 Small 
    share-
    holders
 Foreign 
    share- 
    holders |  Bank1
 Bank2
 Bank3
 Bank4
 Bank5 |

## OLS regressions of CAR (-1,+51)

|  | CAR(-1,+51) | CAR(-1,+51)       |
| --- | --- | --- |
| Prior Relationship
Prior Relationship* Loan Finance
Locational Advantage
Main Creditor Bank
Log_Age
Log_Size
Sales Growth
Profit/Interest
Bond Finance
Equity Finance
Chaebol
#Closed/#Lending Banks 
Loan_Closed/Loan_All
Collateralized Loan
Bank 1
Bank 2
Bank 3
Bank 4
Intercept | -0.174**(-2.012)

0.196(1.513)
-0.012(-0.084)
0.249(1.629)
-0.014(-0.142)
-0.154(-1.081)
0.007(0.333)
-0.566**(-2.155)
-2.261***(-4.862)
-0.161(-1.593)
-0.136(-0.213)
-0.193(-0.604)
0.034(0.429)
0.067(0.851)
-0.176*(-1.684)
0.009(0.088)
-0.140(-1.431)
0.527(0.559) | 0.436*(1.719)
-1.147***(-2.697)
0.176(1.498)
0.026(0.176)
0.262*(1.828)
0.007(0.080)
-0.145(-1.141)
0.014(0.753)
-0.940***(-3.300)
-2.639***(-5.441)
-0.147(-1.537)
-0.140(-0.240)
-0.160(-0.540)
0.020(0.286)
0.074(1.042)
-0.208**(-2.050)
-0.023(-0.221)
-0.136(-1.416)
0.552(0.715) |
| F test | 3.580*** | 3.820*** |
| R-square | 0.333 | 0.368 |

***OLS regressions of CAR (-1,+51)***

**Three firm ownership variables are included in the regressions.**

## Probit regressions of the selection equation

|  | [1] | [2] | [3] |
| --- | --- | --- | --- |
| Prior Relationship 
Market/Book Value
Prior Relationship*Market/Book Value
Locational Advantage
Main Creditor Bank
Log_Age
Log_Size
Sales Growth
Bond Finance
Equity Finance
Chaebol
Loan_Closed/Loan_All
Collateralized Loan
Bank 1
Bank 2
Bank 3
Bank 4
Intercept | 2.312***(4.350)
1.502**(1.966)
-4.929***(-3.325)

-0.372 (-1.276) | 2.307***(3.692)
1.925*(1.937)
-4.599**(-2.365)
0.851*(1.811)
-0.221 (-0.437)
0.091 (0.122)
0.354 (0.948)
0.300 (0.549)
-0.177 (-0.200)
-2.994*(-1.674)
-0.037 (-0.095)
4.101*(1.909)
-0.071 (-0.273)

-3.562(-1.010) | 2.719***(4.007)
2.056*(1.919)
-5.257**(-2.456)
0.882*(1.747)
-0.174 (-0.297)
-0.124 (-0.160)
0.525 (1.174)
-0.040 (-0.071)
0.277 (0.295)
-2.650 (-1.397)
-0.140 (-0.310)
3.452*(1.676)
-0.243 (-0.839)
0.508 (1.366)
0.348 (0.893)
-0.370 (-1.145)
0.082 (0.209)
-5.688 (-1.439) |
| Chi-square | 20.850*** | 25.030** | 47.810*** |
| Pseudo R-square | 0.167 | 0.277 | 0.343 |

**Three firm ownership variables are included in the regressions.**

## Heckman estimation of CAR(-1,+51) for the subsample

|  | [1] | [2] | Full sample |
| --- | --- | --- | --- |
| Prior Relationship
Prior Relationship* Loan Finance
Locational Advantage
Main Creditor Bank
Log_Age
Log_Size
Sales Growth
Profit/Interest
Bond Finance
Equity Finance
Chaebol 
Bank 1
Bank 2
Bank 3
Bank 4
Inverse Mills ratio
Intercept | 0.545*(1.729)
-1.073**(-1.966)
0.200 (1.241)
-0.023 (-0.118)
0.330 (1.276)
-0.130 (-1.325)
0.037 (0.201)
-0.047 (-0.894)
-0.774*(-1.874)
-3.023***(-4.255)
-0.158 (-1.362)

0.308 (0.687)
1.336 (1.465) | 0.513*(1.673)
-0.933*(-1.674)
0.283*(1.816)
-0.025 (-0.125)
0.365 (1.543)
-0.093 (-0.929)
0.010 (0.058)
-0.044 (-0.809)
-0.788*(-1.891)
-2.941***(-4.268)
-0.131 (-1.229)
0.111 (1.217)
-0.148 (-1.308)
0.059 (0.497)
-0.141 (-1.121)
0.554 (1.128)
0.820 (0.948) | 0.486**(2.104)
-1.237***(-3.095)
0.156 (1.430)
0.025 (0.172)
0.255*(1.853)
0.015 (0.188)
-0.129 (-1.099)
0.014 (0.781)
-0.973***(-3.516)
-2.653***(-5.870)
-0.144 (-1.551)
0.069 (1.038)
-0.217**(-2.283)
-0.043 (-0.485)
-0.143 (-1.573)

0.483 (0.695) |
| F test   | 2.880*** | 3.060***
0.385 | 4.670*** |
| R-square | 0.326 |  | 0.371 |
| No. of firms | 82 | 82 | 118 |

## Main Results of Part 1

- Overall effect on firm value in the stock market: _positive_
- _Loss of the relationship-specific advantage_ with the closed banks is outstripped by the _gain from good quality_ of the acquiring banks.
- Effect of the pre-existing relationships on the positive valuation: _negative_
- _Informational advantage_ from the pre-existing relationships is more than offset by banks’ _incentives to misuse the information._
- The larger the size of pre-existing loan, the more negative the effect of pre-existing relationships.

## Overview of Theory in Part 2 Market’s valuation of bank’s lending decisions

| Firms with prior relationships
                   (Type P)

 whether to renew loans to good 
  firm or bad firm (potentially more 
  informed decisions).

 investor’s concerns arise from  
  bank’s incentive to renew bad firm.

 bank’s loan renewal does not 
  signal good borrower quality 
  when bank holds large bad loans | Firms with no prior relationships
                       (Type N)

 whether to invest in costly screen-
  ing to identify good firm (potentially
  less informed decisions).

 investor concerns arise from  
  bank’s incentive not to screen.

 bank’s loan renewal does signal 
  good borrower quality 
  when the screening costs are low. |
| --- | --- |

## Slide 15

##    Loan Announcement Effects 

## Motivation of Part 3

- Firm’s abnormal stock returns to estimate the net gain for the firm may not tell the whole story .
- For example, the market’s reactions to the event may be inconsistent with the actual behavior of loan officers of the acquiring banks.
- Examine directly how the pre-existing relationships between banks and borrowers affect the banks’ lending decisions.
- whether the lending relationship is maintained.
- how the size of loans changes.

## Random effect panel regressions of changes in loan size for the subsample

**All other control variables are included in the regressions.**

## Main Results

- Banks tend to continue relationships with firms that have _prior relationships_ even when their market values are lower.
- Evidence for conflicts of interest
- Bank is aggressive in expanding loans to firms that have _no prior relationships_ once the new relationships are continued.
- Value of bank relationship to its client firms decline over time.
- Bank quality does not necessarily conveys risk classes of its  client firms.

## Contributions

- Investigates in great detail the effect of pre-existing relationship between banks  and borrowers
-       on banks’ lending decisions and market’s reactions to the lending decisions.
- Sheds light on the fundamentals of bank-borrower relationships,
- especially the dark sides of banking relationships:
-        conflicts of interest.

## Policy Implications

- Underscores the importance of the specific mechanisms employed to replace failed banks – the liquidation of banks followed by transfers of their loans to better banks can make client firms better off.
- Mitigates the policy-maker’s concerns about potential negative effects of banking sector restructuring on the values of sound client firms of failed banks.
- Suggests that the intensity of firms’ pre-existing relationships with acquiring banks is important in understanding how successful a bank consolidation is in speeding up the resolution of financially distressed firms.