Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring

59 Pages Posted: 14 Dec 2014

See all articles by Sudarshan Jayaraman

Sudarshan Jayaraman

University of Rochester - Simon Business School; Simon Business School, University of Rochester

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School; Financial Theory Group; European Corporate Governance Institute (ECGI); Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering

Date Written: December 12, 2014

Abstract

The role that banks play in screening and monitoring their borrowers is well understood. However, these bank activities are costly and unobservable, thus difficult to contract upon. This introduces the possibility of shirking and leads to the question – who monitors the monitor? Financial intermediation theories posit that bank capital structure plays such a role in incentivizing banks to monitor their borrowers. Both bank debt and bank equity have been proposed in various theories as providing the discipline to induce banks to monitor. However, empirical evidence on how bank capital structure influences borrower monitoring is scant. To circumvent identification concerns with regressing (unobservable) bank monitoring on (endogenous) bank capital structure, we use variation in country-level creditor rights to capture banks’ need to monitor their borrowers. We develop a theoretical model in which greater ex-post protection offered to lenders (i.e., banks) during borrower bankruptcy/renegotiation reduces the bank’s ex-ante incentives to monitor. This is because the greater salvage value of bank loans reduces the bank’s expected loss from not monitoring. Our model also examines how banks alter their capital structures in response to changes in their country’s creditor rights, and shows that the reduced demand for bank monitoring induced by stronger creditor rights induces the bank to shift its capital structure away from the source of financing that induces it to monitor. We find empirically that increases in creditor rights result in banks tilting their capital structures away from equity and towards deposits. We verify (theoretically and empirically) that these demand-based tilts in bank capital structure are not explained by supply-side effects (i.e., creditor rights make it cheaper to supply bank debt), and conclude that bank equity is a stronger source of discipline on banks than bank debt.

Keywords: Bank capital, bank monitoring, creditor rights, bank leverage

JEL Classification: G15, G21, G32

Suggested Citation

Jayaraman, Sudarshan and Jayaraman, Sudarshan and Thakor, Anjan V., Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring (December 12, 2014). Simon Business School Working Paper No. FR 15-11, Available at SSRN: https://ssrn.com/abstract=2537390 or http://dx.doi.org/10.2139/ssrn.2537390

Sudarshan Jayaraman (Contact Author)

Simon Business School, University of Rochester ( email )

Rochester, NY 14627
United States
585-275-3491 (Phone)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States
585-275-3491 (Phone)

Anjan V. Thakor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Financial Theory Group ( email )

United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Massachusetts Institute of Technology (MIT) - Laboratory for Financial Engineering ( email )

100 Main Street, E62-618
Cambridge, MA 02142
United States

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