Thursday, April 16, 2015

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Equity Sparks Bank Monitoring
Sudarshan Jayaraman

Associate Professor Sudarshan Jayaraman takes an international
look at the link between laws protecting creditors and banks’
incentives to monitor their borrowers.
In the highly leveraged world of banking, what spurs banks to monitor their borrowers: bank debt or equity?

Theories abound suggesting bank capital structure plays a key role in encouraging banks to monitor their borrowers. But bank activities are hard to observe, and testing what form of capital structure spurs monitoring is hard to establish.

“How hard does a bank manager work? And does he or she work harder when the bank has more equity or more debt in its balance sheet?” says Simon associate professor Sudarshan Jayaraman. “We can’t really see the manager perform his day-to-day duties. We can’t observe it as researchers.”

In a working paper, “Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring,” Jayaraman and coauthor Anjan Thakor test prevailing theories in a new way. The coauthors examined changes to creditor rights in more than a dozen countries to understand what motivates banks to monitor their borrowers.

Some countries have strong laws protecting creditors, while others do not. In countries where such laws are on the books, banks have less incentive to monitor. That’s because there’s a legal process in place to recoup at least some of their losses should the bank not monitor and the borrower default on a loan.

The authors also found strong evidence that a climate of improved creditor rights spurs banks to shift their capital structures away from equity and toward deposits.

“What we find is that equity is providing banks with the incentives to monitor their borrowers,” Jayaraman says. “So why are banks so risky with so much debt? We don’t know; all we know is that’s not for monitoring. Debt doesn’t seem to provide monitoring incentives; it’s equity.”

In addition, the authors ran tests that showed such shifts in capital structure are not explained by supply-side effects—for example, that bank creditors are more willing to lend to banks when creditor rights become stronger. Their conclusion: Bank equity is a stronger source of discipline on banks than bank debt.

—Sally Parker

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