Close-Relationships between Banks and Firms: Is it Good or Bad?

In this paper we investigate the issues involved in cross-ownership between banks and firms. The idea is that congruity among the parties in control of the bank and the firm allows savings in monitoring costs, but gives rise to a conflict of interest with outside investors of the bank, such as depositors. In a world of asymmetric information between investors and entrepreneurs, monitoring can be valuable for creditors, by improving entrepreneurial incentives to choose good projects whenever external finance is needed. However, monitoring is costly. Closer relationships between banks and firms as, for instance, in the case of cross-ownership between banks and firms, reduce monitoring costs. The increased congruence between the parties in control of the bank and of the firm reduces the need of information for the banker about the projects that seek finance. However, it might give rise to a conflict of interest, particularly in the choice of the project to be financed by the bank, for which depositors pay the cost through an increasing risk of bankruptcy. In other words, when the banker, by acting as an entrepreneur, chooses to finance a bad project on his own project, he might increase the risk of bankruptcy for the bank, reducing the value of the claims in the hands of depositors. Nevertheless, we show in this paper that there are benefits from cross-ownership, under the condition that the bank involved in the relationship is debt financed and well diversified. The conflict of interest is, in fact, less of a problem when the bank is debt financed and diversified. The reason is that, as diversification increases, debt claims converge to a fixed promise to depositors. Thus, the banker becomes the residual claimant of all the gains from choosing the good project and can credibly commit to make the right choice when financing his own business