Do Banks Provide Financial Slack?

Abstract

We study the decision to choose bank debt rather than public securities in a firm's marginal financing choice. Using a sample of 500 firms over the 1980 to 1993 time period, we find that firms are relatively more likely to choose bank loans when variables that measure asymmetric information problems are elevated. The sensitivity of the likelihood of choosing bank debt to information problems is greater for firms with no public debt outstanding. These results are consistent with the hypothesis that banks help alleviate asymmetric information problems and that firms weigh these information benefits against a wide range of contracting costs when choosing bank financing. WHY DO SOME F IRMS BORROW from public sources while others rely exclusively on private lenders? The answer to this question is not well understood. Existing theories suggest that a firm must consider the tradeoff between the benefits and costs of bank debt financing relative to other potential financing choices. The potential benefits of bank financing include low moral hazard and adverse selection costs and ease of renegotiation in financial distress. 1 The potential costs of bank financing include monitoring costs, suboptimal liquidation outcomes, and distortions induced by information monopolies. 2 The goal of this paper is to identify whether adverse selection problems inf luence a firm's choice between new bank debt, public debt, or common stock. In particular, we are interested in assessing the empirical validity of the hypothesis that banks have the ability to accurately price a firm's claims, thus inducing a preference for firms that are undervalued by the market to 1383 choose bank finance. 3 Our analysis is motivated by existing "pecking order" or market timing models, which suggest that firms tend to sell common stock, and, to a lesser extent, risky public debt, when their securities are overvalued by outsiders~i.e., the public!. If, as many have argued, banks can be viewed as insiders, then similar reasoning would suggest that firms that are undervalued by the public markets will be more likely to choose bank debt. We will refer to the possibility that banks can accurately price a firm's claims, thus alleviating adverse selection problems, as the information benefit of bank debt financing.In choosing to use bank debt, a firm must weigh these information benefits against several potential costs that may be induced by a bank debt contract. These potential costs include agency costs, monitoring costs, financial distress costs, information monopoly costs, and transactions costs. A firm's financing choice will depend not on the absolute magnitude of these costs, but rather on the magnitude of these costs relative to the firm's other potential financing choices. For ease of exposition, we will use the term relative contracting costs to refer to the aggregate size of these contracting costs for bank debt relative to public securities.Previous research suggests that these relative contracting costs will vary across firms. For firms where bank...

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