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).

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 % Firms’ pre-existing relationships with the acquiring banks are identified.

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 MeanMedian [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) [22/96]*** (+6,+51)22.39*** (3.46)27.09 [74/44]*** (-1,+51)8.73 (1.26) [65/53]*

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 (-1,+1) (-1,+51)

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

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 **(-2.012) 0.196(1.513) (-0.084) 0.249(1.629) (-0.142) (-1.081) 0.007(0.333) **(-2.155) ***(-4.862) (-1.593) (-0.213) (-0.604) 0.034(0.429) 0.067(0.851) *(-1.684) 0.009(0.088) (-1.431) 0.527(0.559) 0.436*(1.719) ***(-2.697) 0.176(1.498) 0.026(0.176) 0.262*(1.828) 0.007(0.080) (-1.141) 0.014(0.753) ***(-3.300) ***(-5.441) (-1.537) (-0.240) (-0.540) 0.020(0.286) 0.074(1.042) **(-2.050) (-0.221) (-1.416) 0.552(0.715) F test3.580***3.820*** R-square 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) ***(-3.325) (-1.276) 2.307***(3.692) 1.925*(1.937) **(-2.365) 0.851*(1.811) (-0.437) (0.122) (0.948) (0.549) (-0.200) *(-1.674) (-0.095) 4.101*(1.909) (-0.273) (-1.010) 2.719***(4.007) 2.056*(1.919) **(-2.456) 0.882*(1.747) (-0.297) (-0.160) (1.174) (-0.071) (0.295) (-1.397) (-0.310) 3.452*(1.676) (-0.839) (1.366) (0.893) (-1.145) (0.209) (-1.439) Chi-square20.850***25.030**47.810*** Pseudo R-square 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) **(-1.966) (1.241) (-0.118) (1.276) (-1.325) (0.201) (-0.894) *(-1.874) ***(-4.255) (-1.362) (0.687) (1.465) 0.513*(1.673) *(-1.674) 0.283*(1.816) (-0.125) (1.543) (-0.929) (0.058) (-0.809) *(-1.891) ***(-4.268) (-1.229) (1.217) (-1.308) (0.497) (-1.121) (1.128) (0.948) 0.486**(2.104) ***(-3.095) (1.430) (0.172) 0.255*(1.853) (0.188) (-1.099) (0.781) ***(-3.516) ***(-5.870) (-1.551) (1.038) **(-2.283) (-0.485) (-1.573) (0.695) F test2.880***3.060*** *** R-square No. of firms82 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.

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.