Academic journal article International Journal of Management

Loan Management and Conflict of Interest between Equity and Debt-Holders under Capital Regulations: An Analysis within the Banking Sector

Academic journal article International Journal of Management

Loan Management and Conflict of Interest between Equity and Debt-Holders under Capital Regulations: An Analysis within the Banking Sector

Article excerpt

This paper analyzes a bank's lending and interest conflicts between equity-holders and debt-holders under a risk-based system of capital standards. We find that there is no interest conflict if the bank alternates its management objectives in accord with its loan default realization. The bank's lending is a decreasing function of the capital-to-deposits ratio under its equity value maximization with the realization of a good state of the world becoming worse, or under its debt value maximization with the realization of a bad state becoming better.

I. Introduction

Banks and regulatory authorities must always deal with asset quality problems. In recent years, these problems have plagued banks and other financial institutions. Concerns about bank asset quality and bank failures have promoted regulators to adopt a riskbased system of capital regulation. One basic justification for this system, as Zarruk and Madura (1992) demonstrates, is to force a bank's capital position to reflect its asset portfolio risk. Capital can help protect the safety and soundness of individual institutions. The argument concerning the rationale for capital is relatively non-controversial and is probably widely held. Support for the argument above may be found, for example, in Berger, Herring, and Szego (1995).

Miller (1995) further argues that there is some level of capital that is consistent with the interests of the banking firm and the regulatory and supervisory objectives of safety and soundness. This argument strikes a balance between the objectives of the banking firm and those of regulators, which in general are not identical. Another justification, as Cecchetti (1999) demonstrates, is to ensure that the incentive of a bank is consistent with the goal of safeguarding the interests of those who hold that bank's liabilities. Thus, a principal-agent problem of interest conflicts arises because of the asymmetrical information available on the risk-return attitudes that equity-holders ignore in reductions in bankrupt states because the debt-holders become the residual claimants. This paper examines the relations among capital regulation, interest conflict, and optimal bank lending. Since a change in the capital-to-deposits ratio can affect bank lending, our results address a key issue: what are the most likely effects of the risk-based capital guidelines on bank lending, taking interest conflicts between equity-holders and debtholders into account.

Our paper builds on literature examining capital regulation and bank behavior. These studies include those that examine capital regulation and loan rate decision (for example, Zarruk and Madura, 1992, and Lin and Teng, 2001), and those that examine capital regulation and bank objective decision (for example, Kim and Santomero, 1988, Rochet, 1992, and Beatty and Gron, 2001). Following previous literature, we further study the consequences of capital regulation and loan-rate setting on bank objective choices. Brander and Lewis (1986) analyze the limited liability effect of debt financing, which demonstrates the interest conflicts between equity-holders and debt-holders. Brander and Lewis point out several applications to the limited liability effect in an imperfectly competitive banking industry although their framework is limited to a productive industry. We thus extend their concept to analyze bank loan management in this paper. The model developed here analyzes the limited liability effect of bank lending in which the bank is subject to prevailing risk-based capital regulation.

The major conclusion of this paper is that there is no interest conflict between equityholders and debt-holders if the bank alternates its operative objectives in accord with its loan default realization under capital regulation. Comparative static results show that under the equity value maximization with the realization of the good state of the world becoming worse, or under the debt value maximization with the realization of the bad state of the world becoming better, the bank's lending is a decreasing function of the capital-to-deposits ratio. …

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