PUBLIC POLICY PUBLIC POLICY PERSPECTIVES ON PERSPECTIVES ON

CORPORATE FINANCE:CORPORATE FINANCE:Agency Paradigm and Financial CrisisAgency Paradigm and Financial Crisis

Lemma W. SenbetLemma W. Senbet

University of MarylandUniversity of Maryland

2006 NTU International 2006 NTU International Conference on FinanceConference on Finance

Taipei, TaiwanTaipei, Taiwan

December 13-14, 2006 December 13-14, 2006

Issues of Broad Public Issues of Broad Public PolicyPolicy

Agency Paradigms in Corporate FinanceAgency Paradigms in Corporate Finance The Consequences of Limited LiabilityThe Consequences of Limited Liability

John, Nair, Senbet, 2006John, Nair, Senbet, 2006 Optimal Bankruptcy RulesOptimal Bankruptcy Rules Sequencing of Financial SystemsSequencing of Financial Systems

Bank-based or market-basedBank-based or market-based Functionality of financial systemsFunctionality of financial systems

Optimal Banking RegulationOptimal Banking Regulation Role of incentives and market disciplineRole of incentives and market discipline Political economyPolitical economy

John, Saunders, Senbet, John, Saunders, Senbet, RFS 2000RFS 2000 Cull, Sorge, SenbetCull, Sorge, Senbet, JMCB 2005, JMCB 2005

Financial Sector Reforms in Financial Sector Reforms in Emerging EconomiesEmerging Economies

Functional PerspectiveFunctional Perspective Capital Market DevelopmentCapital Market Development PrivatizationPrivatization

Markets for corporate controlMarkets for corporate control Diversity of ownership and fair pricing Diversity of ownership and fair pricing

Regionalization of markets (e.g., Regionalization of markets (e.g., African stock markets)African stock markets)

Capital mobility and global financial Capital mobility and global financial crisiscrisis Corporate finance paradigms and financial Corporate finance paradigms and financial

crisiscrisis

Distorted Incentives and Distorted Incentives and Financial Crisis In Emerging Financial Crisis In Emerging

Economies: Economies: Agency ApplicationAgency Application

•**(Based on Amar Gande, (Based on Amar Gande, Kose John, Lemma Senbet Kose John, Lemma Senbet

“Bank Incentives, Economic “Bank Incentives, Economic Specialization, and Financial Specialization, and Financial

Crisis in Emerging Crisis in Emerging Economies” (2006)Economies” (2006)

MotivationMotivation Root cause of a financial crisis arises from the Root cause of a financial crisis arises from the

volatility of economic fundamentals driven by:volatility of economic fundamentals driven by: the degree of economic specialization,the degree of economic specialization, mode of financing of investment opportunities. mode of financing of investment opportunities.

Currency instability and excessive debt are Currency instability and excessive debt are factors that aggravate the root cause.factors that aggravate the root cause.

Corporate finance (micro) paradigm.Corporate finance (micro) paradigm. Macro explanations of financial crises: For Macro explanations of financial crises: For

example,example,- Allen and Gale (2000)- Allen and Gale (2000)- Kodres and Pritsker (2002)- Kodres and Pritsker (2002)- Bris and Koskinen (2002)- Bris and Koskinen (2002)

Main ResultsMain Results

Economic specialization and financial Economic specialization and financial crisis:crisis: Probability of a financial crisis Probability of a financial crisis increases with the degree of economic increases with the degree of economic specialization. specialization.

Economic specialization: whether an economy Economic specialization: whether an economy is specialized in a few products/activities.is specialized in a few products/activities.

Financial crisis: low payoff for all firms – joint Financial crisis: low payoff for all firms – joint failure statefailure state

Main ResultsMain Results

Limited internal financing.Limited internal financing. Role of banks:Role of banks: Bank debt financing (most Bank debt financing (most

common source of financing in emerging common source of financing in emerging markets) has two effects on probability of markets) has two effects on probability of financial crisis:financial crisis: Financial Access Effect (+): Increase menu of Financial Access Effect (+): Increase menu of

projects financed => Lowers degree of projects financed => Lowers degree of economic specialization => Lowers the economic specialization => Lowers the probability of financial crisis. probability of financial crisis.

Leverage Effect (-): Induces well-known debt Leverage Effect (-): Induces well-known debt induced risk-shifting => Raises the probability induced risk-shifting => Raises the probability of a financial crisis.of a financial crisis.

Main ResultsMain Results Examine commonly employed mechanisms to Examine commonly employed mechanisms to

manage financial crisis: Deposit insurance, Loan-manage financial crisis: Deposit insurance, Loan-guarantees, and Bailouts. We focus on bailouts.guarantees, and Bailouts. We focus on bailouts.

Bailout: repayment of debt obligations of Bailout: repayment of debt obligations of corporate sector to banks in a financial crisis.corporate sector to banks in a financial crisis.

Role of bailouts:Role of bailouts: Do they have the desired effect Do they have the desired effect of lowering financial crisis by increasing financial of lowering financial crisis by increasing financial access effect?access effect? The unintended consequence: The unintended consequence:

Bank Debt Concentration Effect (-): Increases the degree of Bank Debt Concentration Effect (-): Increases the degree of economic specialization. economic specialization.

Implications for currency induced financial crisis Implications for currency induced financial crisis and contagion.and contagion.

Main ResultsMain Results

Ex anteEx ante solution mechanisms: solution mechanisms: Focused Focused towards prevention than ex post resolution towards prevention than ex post resolution of a crisis. Consists of two tax structures of a crisis. Consists of two tax structures that minimize the probability of a financial that minimize the probability of a financial crisis for any targeted investment policy:crisis for any targeted investment policy: Bank tax structure: Eliminates bank debt Bank tax structure: Eliminates bank debt

concentration>> concentration>> changes bank incentiveschanges bank incentives Corporate tax structure: ameliorates leverage Corporate tax structure: ameliorates leverage

effect >> effect >> concavifying the after-tax payoffsconcavifying the after-tax payoffs

Testable predictions and policy implicationsTestable predictions and policy implications

Figure 1Figure 1

Fcy Loans

Interest

Interest

Loans

Lender of Last Resort

Potential Bailout

Taxes

Taxes

External Intermediary

Social Planner

Local Firm

External Lenders

Local Bank

Potential Bailout

Tax/Warrant Solution

ModelModel

t=0 t=1 t=2 Issue claims Investment Claims Settled Opportunities appear

-IC Safe IC

HC

q

-IC Risky

LC

Incomplete contracting:

- Private information: q ~ U[0,1]

Optimal Investment Policy with Optimal Investment Policy with Unconstrained FinancingUnconstrained Financing

Investment policy {qInvestment policy {qee} -- invest in risky } -- invest in risky asset for q ≥ qasset for q ≥ qee and safe asset for q < and safe asset for q < qqee. .

Idealized investment policy for a social Idealized investment policy for a social planner.planner.

(2) . CC

CCe

LH

LIq

.)1(2

1])(1[

2

1)( 22

Ce

Ce

Cee LqIqHqqV (3)

Economic Specialization and Economic Specialization and Financial CrisisFinancial Crisis

Proposition 1: The probability of a financial crisis Proposition 1: The probability of a financial crisis increases in the degree of economic increases in the degree of economic specialization for any given firm-level investment specialization for any given firm-level investment policies. policies.

Interpretation:Interpretation: Probability of a financial crisis Probability of a financial crisis- Increasing in - Increasing in ρρ (high value implies economic (high value implies economic

specialization) specialization)

- Decreasing in q (low values implies more risky policies) - Decreasing in q (low values implies more risky policies)

.)|( 12 LLP (4)

.)~1()~1(2

1)()|( )() ( 2

2111221 qqLPLLPLLPCrisisFinancialP (6)

Debt and Financial Crisis Debt and Financial Crisis (Exogenous (Exogenous ρρ))

Proposition 2: The probability of a financial crisis Proposition 2: The probability of a financial crisis is higher when firms have debt as compared to is higher when firms have debt as compared to financing fully with equity, and it is increasing in financing fully with equity, and it is increasing in the debt levels of the firms. the debt levels of the firms.

Having debt alone is not sufficient: linkage is Having debt alone is not sufficient: linkage is dampened for low values of dampened for low values of ρρ..

NextNext: Endogenizing : Endogenizing ρρ -- if external financing -- if external financing entails agency costs, menu of projects financed entails agency costs, menu of projects financed depends on availability and form of financing. depends on availability and form of financing.

.)1()1(2

12

21 FF

F qq (10)

Numerical ExampleNumerical Example

Ic = 1, Hc = 2, Lc = 0.5 => qe = 0.33.F = 0.65 => qF = 0.26; F = 0.80 => qF =

0.09.Probability of Financial Crisis

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0 0.2 0.4 0.6 0.8 1

rho

Pro

ba

bili

ty phi_e

phi_F_65

phi_F_80

Economic Specialization in a Economic Specialization in a Multi-firm EconomyMulti-firm Economy

ρρii is correlation of technology i with the basic is correlation of technology i with the basic technology. technology.

If all positive NPV projects can be financed:If all positive NPV projects can be financed:

However, not all projects are financed due to limited However, not all projects are financed due to limited capital as a result of agency costs (Jensen and capital as a result of agency costs (Jensen and Meckling, 1976; Myers, 1977), poor investor protection Meckling, 1976; Myers, 1977), poor investor protection (LLSV 1997, 1998); economic fragility (Rajan and (LLSV 1997, 1998); economic fragility (Rajan and Zingales, 1998). Zingales, 1998).

If projects are financed only with internal financing: If projects are financed only with internal financing:

NextNext: Role of banks as the most commonly available : Role of banks as the most commonly available source of financing. source of financing.

},)(:min{min IqV e (5)

}. and ,)(:min{int WIIqV e (11)

Financial Access Effect, Leverage Financial Access Effect, Leverage Effect, and Financial CrisisEffect, and Financial Crisis

Proposition 3: Bank debt financing has two Proposition 3: Bank debt financing has two effects on the probability of a financial crisis, effects on the probability of a financial crisis, (1) the financial access effect, i.e., higher (1) the financial access effect, i.e., higher access to outside financing for a larger menu access to outside financing for a larger menu of projects => lowers , (2) the leverage of projects => lowers , (2) the leverage effect (Proposition 2) => raises the effect (Proposition 2) => raises the probability of financial crisis probability of financial crisis

}. and ,)(:min{ FFb BWIIqV (12)

intmin b

.)1()1(2

12

21 b

FFb qq (13)

b

Bailouts and Bank Debt Bailouts and Bank Debt ConcentrationConcentration

Proposition 4: Bailouts provide incentives Proposition 4: Bailouts provide incentives for banks to concentrate their loans in the for banks to concentrate their loans in the highest sector possible (i.e., highest sector possible (i.e., ρρ →→ρρmaxmax).). Bailout defined as repayment of debt Bailout defined as repayment of debt

obligations of corporate sector in a financial obligations of corporate sector in a financial crisis.crisis.

(15) ,)]([)(

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maxarg

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212121

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2121

212121

maxmin

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banks

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NPV

(17) .0))(1()1(2

1)][( 21212

212121

21

LLFFqqLLFFNPV LL

Bailout Induced Financial CrisisBailout Induced Financial Crisis

Corollary 1: The probability of a financial crisis is Corollary 1: The probability of a financial crisis is with bailouts is higher than the probability of a with bailouts is higher than the probability of a financial crisis without bailouts.financial crisis without bailouts.

F̂F̂F̂F̂

,)1()1(2

1max2

21 FF

b qq (18)

bb

Solution MechanismsSolution Mechanisms

Focus on prevention than Focus on prevention than ex postex post resolution. resolution.

Ex anteEx ante mechanisms: Two tax structures mechanisms: Two tax structures Bank tax structure: eliminates bank debt Bank tax structure: eliminates bank debt

concentration effect.concentration effect. Corporate tax structure: ameliorates leverage Corporate tax structure: ameliorates leverage

effect.effect.

Reduces the negative effects of bank Reduces the negative effects of bank financing while retaining the positive effect financing while retaining the positive effect (i.e., financial access effect).(i.e., financial access effect).

Incentive Alignment and Fair PricingIncentive Alignment and Fair Pricing

Proposition 5: A tax system characterized by a Proposition 5: A tax system characterized by a marginal tax rate marginal tax rate , tax deductible amount , tax deductible amount (F+(F+ii), where ), where ii is as specified in equation is as specified in equation (20), leads to value maximizing optimal (20), leads to value maximizing optimal policies {qpolicies {qii

ee}. A tax system characterized by a }. A tax system characterized by a tax rate t >= ttax rate t >= tbcbc, where , where ttbcbc is given by equation is given by equation (24) paid by all banks only when they receive (24) paid by all banks only when they receive the full promised payment from the corporate the full promised payment from the corporate sector induces the minimal degree of sector induces the minimal degree of economic specialization (economic specialization (ρρminmin).).

(20) }{)1(

ii LF

(24) 21

2121

FF

LLFFtt bc

Financial Crisis with Optimal Financial Crisis with Optimal InvestmentInvestment

Corollary 2: Under the solution mechanism proposed in Corollary 2: Under the solution mechanism proposed in Proposition 5, investment is at the optimal level {qProposition 5, investment is at the optimal level {qee}, }, and the resulting probability of a financial crisis is:and the resulting probability of a financial crisis is:

If the cost of financial crisis is high at ρ=ρIf the cost of financial crisis is high at ρ=ρminmin and {q and {qee}, }, the social planner may want to implement a more the social planner may want to implement a more conservative investment policy {qconservative investment policy {qss}. }.

This can be implemented by our proposed solutions. This can be implemented by our proposed solutions. However, it may come at the cost of economic growth and However, it may come at the cost of economic growth and

efficiency. This may explain conservative investment efficiency. This may explain conservative investment policies (low growth) in small specialized economies.policies (low growth) in small specialized economies.

.)1()1(2

1min2

21min eee qq (25)

Discussion of ResultsDiscussion of Results

Efficacy of other solution mechanisms:Efficacy of other solution mechanisms: Loan guaranteesLoan guarantees Deposit insuranceDeposit insurance Taxation of short-term debtTaxation of short-term debt

Foreign currency debt: Corollary 3. Foreign currency debt: Corollary 3.

Implementation issuesImplementation issues

Empirical ImplicationsEmpirical Implications

Empirical/Policy ImplicationsEmpirical/Policy Implications The lower the degree of economic specialization, the less The lower the degree of economic specialization, the less

susceptible an economy is to a financial crisis.susceptible an economy is to a financial crisis.

Higher the availability of external finance, lower the Higher the availability of external finance, lower the probability of a financial crisis (provided the leverage effect probability of a financial crisis (provided the leverage effect is contained by a solution such as ours).is contained by a solution such as ours).

Higher the extent of government safety nets, higher is the Higher the extent of government safety nets, higher is the debt concentration of bank loans and higher the likelihood debt concentration of bank loans and higher the likelihood of a financial crisis.of a financial crisis.

Our analysis shows government safety nets should be fairly Our analysis shows government safety nets should be fairly priced and accompanied by commensurate improvements priced and accompanied by commensurate improvements in the incentive structure.in the incentive structure.

Financial Crisis and Economic Specialization

(1) (2) (3) (4)

Coeff T-stat Coeff T-stat Coeff T-stat Coeff T-stat

Constant -0.05 -0.93 -0.11 -2.22c -0.04 -5.76a -0.05 -0.62

Econ Specialization 1.36 8.48a 1.05 6.21a 1.02 5.76a 1.16 3.65a

Emerging 0.26 5.87a 0.27 6.13a 0.97 18.67a

Year Dummies no no yes yes

Country Dummies no no no yes

Adjusted R2 0.118 0.178 0.164 0.621Observations 427 427 427 427

Probability of Financial Crisis and Economic Specialization

(1) (2) (3) (4)

Coeff T-stat Coeff T-stat Coeff T-stat Coeff T-stat

Constant -1.69 -6.39a -1.96 -7.19a -6.23 -10.74a -2.26 -2.00c

Econ Specialization 4.36 5.21a 3.50 4.23a 3.37 4.01a 9.15 3.13a

Emerging 0.79 5.42a 0.86 5.82a 6.32 7.07a

Year Dummies no no yes yes

Country Dummies no no no yes

Psuedo R-squared 0.099 0.153 0.161 0.279Observations 427 427 427 427

ConclusionsConclusions Model of economic specialization, mode of financing Model of economic specialization, mode of financing

and financial crisis.and financial crisis.

Illustrating how agency problems act as a channel for Illustrating how agency problems act as a channel for propagating other shocks, e.g., currency risk. propagating other shocks, e.g., currency risk.

Role of banks: financial access and leverage effects.Role of banks: financial access and leverage effects. Role of bailouts: bank debt concentration.Role of bailouts: bank debt concentration.

Propose ex ante mechanisms based on two tax Propose ex ante mechanisms based on two tax structures to reduce negative effects of bank structures to reduce negative effects of bank financing while retaining the positive effect. financing while retaining the positive effect.

Implications for economic growth and efficiency.Implications for economic growth and efficiency.