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Long-Term Investment and Monitoring in Financial Relationships
Abstract
Are firms prone to pursuing short-term goals, although long-run strategies would be superior? Especially in the USA, with the surge of takeovers in the 1980s and the increased use of stock options as managerial incentive schemes, this question has been related to possible deficiencies in the workings of the capital markets. For example, in a discussion of the recent wave of hostile takeovers in the USA, Scherer (1988) writes:
Perhaps the most controversial and least understood consequence of the 1980s takeover movement is its alleged propensity to shorten managerial decision-making horizons and bias profit maximization toward the short run. If the allegation is true, it could be the most important implication of takeovers, since American industry is confronted by European and especially Asian rivals who invest heavily and practice penetration and learning curve pricing — manifestations of a long-run strategy.
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Our theory of costly contracts emphasizes that contractual rights can be of two types: specific rights and residual rights. When it is costly to list all specific rights over assets in the contract, it may be optimal to let one party purchase all residual rights. Ownership is the purchase of these residual rights. When residual rights are purchased by one party, they are lost by a second party, and this inevitably creates distortions. Firm 1 purchases firm 2 when firm 1's control increases the productivity of its management more than the loss of control decreases the productivity of firm 2's management.
I modify the uniform-price auction rules in allowing the seller to ration bidders. This allows me to provide a strategic foundation for underpricing when the seller has an interest in ownership dispersion. Moreover, many of the so-called "collusive-seeming" equilibria disappear.
Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition, thus, drives banks to lend to new firms at interest rates that initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation. Copyright 1990 by American Finance Association.
This paper develops a theory of financial intermediation based on minimizing the cost of monitoring information which is useful
for resolving incentive problems between borrowers and lenders. It presents a characterization of the costs of providing incentives
for delegated monitoring by a financial intermediary. Diversification within an intermediary serves to reduce these costs,
even in a risk neutral economy. The paper presents some more general analysis of the effect of diversification on resolving
incentive problems. In the environment assumed in the model, debt contracts with costly bankruptcy are shown to be optimal.
The analysis has implications for the portfolio structure and capital structure of intermediaries.
This book analyses the widely-held view of the merits of the 'bank-based' German system of finance for investment, and shows that this view is not supported by evidence from the post-war period. The institutional features of the German system are such that universal banks have control of voting rights at shareholders' meetings due to proxy votes, and they also have representation on companies' supervisory boards. These features are claimed to have two main benefits. One is that the German system reduces asymmetric information problems, enabling banks to supply more external finance to firms at a lower cost, and thus increasing investment. The other is that German banks are able to mould and control managements of firms on behalf of shareholders, and thus ensure that firms are run efficiently. This book assesses whether empirical evidence backs up these claims, and shows that the merits of the German system are largely myths.
Capital markets are affected at least as much as goods markets by the European Community's drive for greater economic integration. The removal of capital controls on 1 July 1990 has far-reaching consequences for the EMS and for cross-border investment, and plans for economic and monetary union foreshadow fundamental upheavals at the heart of the financial system, in central banking and monetary and fiscal policy. This volume reports the proceedings of a conference on European financial integration held in Rome in January 1990, which was organised by the Centre for Economic Policy Research and the Instituto Mobiliare Italiano. In this volume, leading international experts examine the implications of integration for the structure and regulation of capital markets, the changing relationships between the corporate and banking sectors throughout the Community, the distortionary effects of differing taxation policies among member states and possible means of overcoming them, and alternative routes to European monetary union.
This paper examines the familiar argument that takeover pressure can be damaging because i t leads managers to sacrifice long-term interests in order to boost c urrent profits. If stockholders are imperfectly informed, temporarily low earnings may cause the stock to become undervalued, increasing t he likelihood of a takeover at an unfavorable price; hence the manage rial concern with current bottom line. The magnitude of the problem d epends on a variety of factors, including the attitudes and beliefs o f shareholders, the extent to which corporate raiders have inside inf ormation, and the degree to which managers are concerned with retaini ng control of their firms. Copyright 1988 by University of Chicago Press.
In a corporation with many small owners, it may not pay any one of them to monitor the performance of the management. We explore a model in which the presence of a large minority shareholder provides a partial solution to this free-rider problem. The model sheds light on the following questions: Under what circumstances will we observe a tender offer as opposed to a proxy fight or an internal management shake-up? How strong are the forces pushing toward increasing concentration of ownership of a diffusely held firm? Why do corporate and personal investors commonly hold stock in the same firm, despite their disparate tax preferences?
The authors develop a model in which a large investor has access to a costly monitoring technology affecting securities' expected payoffs. Allocations of shares are determined through trading among risk-averse investors. Despite the free-rider problem associated with monitoring, risk-sharing considerations lead to equilibria in which monitoring takes place. Under certain conditions, the equilibrium allocation is Pareto efficient and all agents hold the market portfolio of risky assets independent of the specific monitoring technology. Otherwise, distortions in risk sharing may occur and monitoring activities that reduce the expected payoff on the market portfolio may be undertaken. Copyright 1994 by University of Chicago Press.
This paper develops a model of inefficient managerial behavior in the face of a rational stock market In an effort to mislead
the market about their firms' worth, managers forsake good investments so as to boost current earnings. In equilibrium the
market is efficient and is not fooled: it correctly conjectures that there will be earnings inflation, and adjusts for this
in making inferences. Nonetheless, managers, who take the market's conjectures as fixed, continue to behave myopically. The
model is useful in assessing evidence that has been presented in che “myopia” debate. It also yields some novel implications
regarding firm structure and the limits of intergation.
The first purpose of this paper is to design a model of governance structure, called the contingent governance, which can control the free-riding problem in teams in the second-best manner. The second is to show, by a new method of comparative static analysis, that the effectiveness of the contingent governance may be enhanced by complementary institutional arrangements of the imperfect labor market and bank-centered financial system. The paper discusses the implications of such institutional complementarity for the dynamic change of the Japanese main bank system and financial system design of transitional economies. Copyright 1994 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
We study a credit model where, because of adverse selection, unprofitable projects may nevertheless be financed. Indeed they
may continue to be financed even when shown to be low-quality if sunk costs have already been incurred. We show that credit
decentralization offers a way for creditors to commit not to refinance such projects, thereby discouraging entrepreneurs from
undertaking them initially. Thus, decentralization provides financial discipline. Nevertheless, we argue that it puts too
high a premium on short-term returns.
The model seems pertinent to two issues: “soft budget constraint” problems in centralized economies, and differences between
“Anglo-Saxon” and “German-Japanese” financing practices.
We analyze incomplete long-term financial contracts between an entrepreneur with no initial wealth and a wealthy investor.
Both agents have potentially conflicting objectives since the entrepreneur cares about both pecuniary and non-pecuniary returns
from the project while the investor is only concerned about monetary returns. We address the questions of (i) whether and
how the initial contract can be structured in such a way as to bring about a perfect coincidence of objectives between both
agents (ii) when the initial contract cannot achieve this coincidence of objectives how should control rights be allocated
to achieve efficiency? One of the main results of our analysis concerns the optimality properties of the (contingent) control
allocation induced by standard debt financing.
Flow of funds data are used to compare methods of finance in 5 countries over the period 1970 to 1985. Many of the problems associated with previous studies are avoided by estimating net instead of gross financing proportions. The degree of consolidation of accounts, reciprocal arrangements between borrowers and lenders and compensating deposit requirements on borrowers no longer distort financing patterns. Corrections for inflation are provided by employing flow rather than stock figures and using own aggregation procedures to derive stock measures. Significant variations in financing emerge. These are not readily explained by traditional descriptions of corporate finance, in particular taxation. As an alternative, the paper suggests that relationships between borrowers and lenders establish forms of commitment that are conducive to the provision of long term finance. The separation between investment and finance, which has been the starting point of corporate finance theory, is untenable in a multiperiod context in which terms of finance define future allocation of control.
This paper characterizes the Japanese main bank system as an arrangement for facilitating reciprocal delegation of monitoring among a set of banks. Reciprocal delegated monitoring allows banks and firms to remain diversified while ensuring that monitoring takes place without duplication, but when monitoring is unobservable, it induces a principal-agent relationship between non-main banks and the main bank. The convention that the main bank bears a disproportionately large share of bank losses is viewed as being part of a contractual arrangement among banks designed to give the main bank adequate incentives to carry out monitoring on behalf of lending banks as a whole. J. Japan. Int. Econ., March 1994, 8(1), pp. 1–21. Faculty of Economics, Osaka University, Toyonaka, Osaka 560, Japan.
The paper presents a dynamic contracting model of myopic firm behaviour caused by the fear of early project termination by
outside investors. Although the parties can conclude longterm contracts, asymmetric information between investors and firms
can make it impossible to implement profitable long-term projects. The paper characterizes the structure of optimal, renegotiation-proof
contracts for unmonitored and monitored finance. Monitoring by investors, although itself subject to distorting incentive
constraints, is shown to be able to overcome the short-term bias of investment and thus to lengthen the firms' planning horizon.
This paper empirically examines how ties between a firm and its creditors affect the availability and cost of funds to the firm. The authors analyze data collected in a survey of small firms by the Small Business Administration. The primary benefit of building close ties with an institutional creditor is that the availability of financing increases. The authors find smaller effects on the price of credit. Attempts to widen the circle of relationships by borrowing from multiple leaders increases the price and reduces the availability of credit. In sum, relationships are valuable and appear to operate more through quantities rather than prices. Copyright 1994 by American Finance Association.
While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profit once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks. Copyright 1992 by American Finance Association.
Of late, concern has been expressed that American managers tend to make decisions that yield short‐term gains at the expense of the long‐term interests of the shareholders. In this paper, we have attempted to investigate managerial incentives for such decisions. We find that, when the manager has private information regarding his or her decisions, there exist situations wherein the manager has incentives to make decisions which yield short‐term profits but are not in the stockholders best interests. This incentive for suboptimal decisions arises because the manager, by taking decisions yielding short‐term profits, hopes to enhance his reputation earlier, thus boosting his wages. We also find that this incentive is inversely related to her experience, the duration of her contract, and the risk of the firm.
By committing to terminate funding if a firm's performance is poor, investors can mitigate managerial incentive problems. These optimal financial constraints, however, encourage rivals to ensure that a firm's performance is poor; this raises the chance that the financial constraints become binding and induce exit. The authors analyze the optimal financial contract in light of this predatory threat. The optimal contract balances the benefits of deterring predation by relaxing financial constraints against the cost of exacerbating incentive problems. Copyright 1990 by American Economic Association.
Exxon Mobil and ConocoPhillips stock price has been predicted using the difference between core and headline CPI in the United States. Linear trends in the CPI difference allow accurate prediction of the prices at a five to ten-year horizon.
In recent years, the tender offer takeover has been praised and damned with a ferocity suggesting that the survival of capitalism is at stake. The truth, as in most disputes with substantial metaphysical content, is more prosaic. Some takeovers enhance economic efficiency, some degrade it, and the balance of effects, though not fully known, is most likely a close one. In this essay I try to lay bare the debate's foundations and bring it back to earth with an injection of evidence.
Capital Structure as a Mechanism of Control: A Cornparison of Financial Systems
- E Berglöf
Jiyu-ka-kokusai-ka jidai no kigyo-kinyu no hendo (Changing Corporate Finance in the Era of Liberalization and Globalization)
- T Horiuchi
Firm Ownership Structure and Investment: Theory and Evidence from German Panel Data
- J A Elston
- JA Elston
Exit, Voice, and Loyalty
- A Hirschman
‘Managerial Incentives for Myopic Investments-A Review of Some Recent Models
- E Bohlin
Are Large Shareholders Effective Monitors? An Investigation of Share Ownership and Corporate Performance
- J Pound
- R J Zeckhauser
On the Theory of Intermediation
- M.-O Yanelle
- M-O Yanelle