Banks and Corporate Decisions: Evidence from Business Groups

• Date: 01 September 2018
• DOI: http://doi.org/10.1111/fima.12214
• Author: Huong N. Higgins
• Published date: 01 September 2018

Banks and Corporate Decisions:

Evidence from Business Groups

Huong N. Higgins∗

Banks who can influence clients’ governance may steer those clients into mergers to reduce

the banks’ own risk. Empirical evidence based on Japan’s mergers and acquisitions (M&As)

during the country’s 1990s banking crisis indicates that acquirers with stronger bank ties made

acquisitions that they would not have normally made. These acquirerslost more shareholder value

via mergers than acquirers with weaker bank ties. The banks’ risk wasreduced, while the banks’

shareholders gained significant excess returns from their borrowers’ mergers. This paper offers

implications for corporate governance of firms with strong bank ties and advances the existing

knowledge on business groups.

This paper is motivated by the prevalence of business groups around the world and the im-

portance of banks at the center of many of them. The literature presents a range of perspectives.

Finance research via agency theory often views business groups as a mechanism to reduce agency

costs by circumventing problems associated with information asymmetries (Hoshi, Kashyap, and

Scharfstein, 1990; Prowse, 1990) or, contrarily, as a tunneling mechanism that increases agency

costs by enabling controlling shareholders to expropriate minority shareholders (Bae, Kang, and

Lee, 2002, 2006; Morck and Nakamura, 2005; Jiang, Lee, and Yue,2010). Management research

via organization theory views business groups as social and resource networks to prop up member

firms through tough times (Khanna and Palepu, 2000; Guillen, 2000; Chang and Hong, 2000;

Hoskisson et al., 2004). Risk sharing is one function often attributed to business groups (Khanna

and Yafeh, 2005). An emerging theme in the literature theorizes that business groups exist for

coinsurance (Jia, Shi, and Wang, 2013) as member firms in distress receive support from the

parent firm of the group and, in return, member fi rms contribute to the parent firm when the

latter is in distress.

Coinsurance is a term that denotes the spreading of risk among multiple parties, for example

via taking turns propping each other up (Jia et al., 2013), trading favors (Fisman and Wang, 2010),

smoothing incomes and reallocating money from one to another (Khanna and Yafeh, 2005), cross

subsidizing the weaker ones (Ferris, Kim, and Kitsabunnarat, 2003), or merging together (Kim

and McConnell, 1977). In the case of merger, coinsurance stems from financial diversification

and deployment of slack. Financial diversification results from the imperfectly correlated cash

flows of the merging firms, which reduces the bankruptcy risk of the total diversified firm

A prior version of this paper has benefited from comments by Karan Bhanot, Oyvind Bohren, Larry Brown, Froystein

Gjesdal, Don Herrmann, Jun-Koo Kang, KojiKojima, Dimitri Koutmos, Erlend Kvaal, John-Christian Langli, Kankana

Mukherjee, Mattias Nilsson, Oghenovo Obrimah, Katsuhiko Okada, David Reeb, Bill Stammerjohan, Cindy Yoshiko

Shirata, Susumu Tokusaki, Wayne Thomas, Takashi Yaekura, Noriaki Yamaji, and participants in meetings sponsored

by Kwansei Gakuin University, Louisiana Polytechnic University, the Norwegian School of Economics and Business

Administration (NHH), the Norwegian Schoolof Management (BI), and the Washington Area Finance Association. Data

collection assistance by Madhurima Bhutkar, Ann Chen, Sunny Khan, Tony Lu, Divya Tandon, and Jinjin Yu is much

appreciated.

∗Huong N.Higgins is a Professor in the Robert A. Foisie Schoolof Business at Worcester PolytechnicInstitute in Worcester,

MA 01609.

Financial Management •Fall 2018 •pages 679 – 713

680 Financial Management rFall 2018

(Levy and Sarnat, 1970; Lewellen, 1971; Higgins and Schall, 1975). Deployment of slack is

the notion that postmerger, slack from the acquirer is deployed to fulfill the target’s obligations

or to redeem the target’s nonperforming loans (Myers and Majluf, 1984; Bruner, 1988). When

one firm’s slack is tapped to cover deficiencies in the other, the risk of the total merged firm is

reduced.

This paper seeks to advance the existing knowledge on business groups by using the bank

perspective to highlight bank influence as both coinsurance and agency factors that should be

considered when studying business groups. Banks play a vital role in a large number of business

groups. In the bank perspective, the strategy, governance, and operations of group firms serve

as risk mitigation for banks at the group’s center. Risk mitigation for banks sometimes means

propping up group firms if the bank’s interest is aligned with the firm’s, but oftentimes this

alignment is not perfect or does not exist.

Specifically, this paper examines banks’ incentive to create coinsurance by steering firms

into mergers. It is typically difficult to observe the impact of banks on firms’ merger activity

as mergers necessitate approval by top stakeholders. In firms that are governed by shareholder

interest, acquisitions that do not enhance shareholder value tend to be disapprovedby shareholders.

Thus, the bank’s directive is often not sufficient for a merger. As a result, the prior literature has

little systematic evidence of bank-led mergers. However, for firms that are strongly influenced

by banks or that are members of bank-centered business groups, banks have the ability to steer

firms. Using data from Japan, where business groups have existed in various forms for centuries

and banks have a strong role in the economy, this paper contributes the first systematic evidence

of banks’ steering firms into mergers for coinsurance.

This paper uses the period 1990-2004, when Japan’s banking sector deteriorated precipitously

(as shown by Japan’s Bank Index depicted in Figure 1). Systematic banking trouble prompted

tougher prudential regulations, which pressured banks to reduce their risk and increase their

coinsurance incentive. This period is and will remain of special interest to researchers who

study capital adequacy regulations and their effects. Moreover, this period is also interesting as

during this time, a large number of Japanese banks were on the verge of noncompliance after

accumulating colossal nonperforming loans. These banks could no longer “evergreen” loans

due to tightened banking supervision, while noncompliant banks could not borrow from their

central banks and were promptly subject to regulatory action. Consequently, meeting capital

requirements became most urgent for these banks, creating a strong coinsurance incentive for

them.

Capital adequacy regulations require that banks’ ratio of capital to risk-weighted assets (hence-

forth “capital adequacy ratio”) stay at or above the specified minimum threshold. Thus, non-

performing loans pose a substantial problem to banks as they reduce loan loss reserves and,

consequently, reduce regulatory capital. Therefore, nonperforming loans exert huge regulatory

costs if banks are already on the verge of noncompliance with the capital requirements. There are

various ways for troubled banks to still clear the regulatory hurdle. One is to issue new equity.

However, this tactic is costly due to asymmetric information involving investors, banks, and bor-

rowers. A second way is to allocate the asset portfolio away from commercial loans, which have

a 100% risk weight, to assets such as risk-free government bonds of Organisation for Economic

Cooperation and Development (OECD) countries, which have0% risk weight (Watanabe, 2005).

Particularly, banks use the traditional bank-led restructuring of distressed firms, which involves

selling off the firms’ assets. However,these sell-offs may not work due to tight bank-firm alliances

or an insufficient recovery of cash to pay back the bank loans. A third and more advantageous

method of restructuring loans to a troubled borrower is to arrange its acquisition by another

client who has unused resources (slack). Postmerger,acquirer slack may be tapped (e.g., through

Higgins rBanks and Corporate Decisions 681

Figure 1. Japan’s Bank Index

Source: Datastream

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liquidation or collaterization) to redeem bank loans to the distressed target.1Thus, banks es-

sentially shift their target loan risk to the acquirer shareholders. Separate from loan redemption

postmerger, financial diversification resulting from joining the merger firms’ cash flows reduces

the default risk of the total merged firm. Overall, banks, especially those on the verge of noncom-

pliance with capital requirements, have the incentive to facilitate a merger between a slack-rich

acquirer and a nonperforming target because of two reasons: first, banks may restructure target

loans with acquirer slack postmerger, thereby improving the bank’s capital adequacy ratio; and

second, a merger creates a financially diversified firm that reduces loan default risk and helps

prevent the bank’s capital adequacy ratio from worsening.

Despite their coinsurance incentive, banks do not usually have the ability to bypass a firm’s

governance to steer them into merger. However, there are a couple of exceptions. First, a bank’s

ability to steer is improvedif they are lenders to both potential merger f irms. This position provides

banks with proprietary knowledge of and access to both the acquirer and the target of a tentative

merger deal (Ivashina et al., 2009). Then, the bank can initiate interest and mediate negotiation

1A merger, by definition, folds one corporation (the target) into another (the acquirer). The target ceases to exist and the

acquirer assumes all assets and liabilities of the target. Without a merger,even if banks control or influence the separate

firms, they have far less flexibility in reducing their loan risk. This is because the legal status of corporations allows

separate firms to have separate limited liabilities, and it allows each firm to cover its disaster with its own assets. The

cost of the limited liability status to debt holders is elaborated by Leland (2007).