This chapter demonstrates the impact of bank-firm relationships on borrowers’ related party transactions. The bank-firm relationship analysis uses two dimensions through which banks gather information from borrowing firms: soft information, gathered through geographical proximity, and inside information, gathered through equity exposure. The chapter’s analysis illustrates that a stronger bank-firm relationship governs the borrowing firm’s tunneling behavior and reduces related party transactions in all perspectives. The in-depth analysis helps to identify the drivers and channels of such effects. A better bank-firm relationship leads to careful control of the lending amount, interest rate, and tenor, further reducing related-party lending. Furthermore, the bank-firm relationship can help banking institutions play a more critical role in the borrowing firm’s board, which can significantly impact corporate governance quality and further reduce tunneling activities.
In regards to the two facets of the borrower-lender relationship used in the literature, both soft information (collected through proximity) and inside information (collected through equity exposure) support the bank’s monitoring power to reduce the borrowing firm’s tunneling activities and to prevent the firm from transferring cash, credit, and goods to related parties. For studying this effect, this chapter builds a unique dataset of banking information and loan-level transactions from Chinese listed firms, combines information on bank branches and data from firms’ financial statements, and creates two measurements of the firm relationship strength in the Chinese market. By bridging the bank-firm relationship proxies with a bank-firm’s related-party transaction data, this chapter applies the combination of the Heckman model and 2SLS IV regression. It provides evidence that bank governance plays a critical role in reducing tunneling activities on the part of borrowing listed firms in the context of China’s pervasive business group organizational structure.
In particular situations, the lending bank continues to show its strong governing effect.
When the ultimate controller faces financial difficulties, a better bank-firm relationship can powerfully reduce the tunneling capital outflow towards the top shareholder. On the other hand, when the listed firm faces a risk of being delisted, a strong bank-firm relationship closely monitors the listed firm to further reduce its RPT activities and ensure the listed firm’s survival.
This chapter contributes a unique dataset of firm loan contracts and creates specific identifiers to research the Chinese corporate governance issue. The results of the anal-ysis also shed light on several issues. First, they demonstrate that Chinese commercial banks play the same monitoring role as developed countries. Second, tunneling behavior, whereby firms borrow from commercial banks and lend to other firms, creates a massive shadow lending market, which poses serious concerns for the Chinese central bank and generates unpredictable financial market risks. If the central bank aims to limit this cat-egory of shadow banking, it should enlist commercial banks’ help and encourage them to monitor their borrowing firms closely. Third, investors looking for firms less prone to jeopardizing the benefits of minority shareholders can use the variables created in this chapter as factors to rank and filter firms in the construction of a portfolio.
Equilibrium bank lending and shadow lending in China
We model and document the endogenous generation of capital transactions between re-lated parties. We show that shadow lending is the market reaction to increased compe-tition in the banking sector. In our model, firms with large capitalizations, which can obtain cheap bank loans, tend to overborrow and then relend to other firms through en-trusted loans. Credit rationing exists since the success of risky investments depends on the effort of the entrepreneurs who lead firms. The bank rations the credit of small firms, and entrusted lending does not alleviate this rationing since shadow banks do not provide a monitoring service. In the presence of shadow lending, the bank increases the lending rate to firms that are engaged in such lending practices. In turn, the profits of these firms improve. However, the bank’s monitoring effort of the firms is reduced, which results in a higher default risk. Entrusted loans thus offer a new channel to provide cheaper financing to small and medium-sized firms, but they increase risks to financial stability.
Keywords: Shadow banking, Entrusted loan, China’s banking, Corporate structure
2.1 Introduction
Despite being the second largest economy in the world, the Chinese financial system relies heavily on the banking sector, as its stock and bond markets are quite underdeveloped compared to those of the US and Europe. According to research by D. J. Elliott and Yan, 2013, banks dominate the Chinese financial system, providing approximately three-fifths of the total credit to the private sector. In contrast to the prediction of traditional pecking-order theory (Stewart and Majluf, 1984), the banking system is the ultimate supplier of enormous financing resources to listed firms in China. By aggregating three external financing cash flows over all Chinese listed firms across years, figure A.1 illustrates the tiny amounts of corporate bond and new share issues in the Chinese market compared with the value of commercial bank loans. In 2015, the total amount of commercial loans newly issued to all listed firms was more than 6 trillion yuan and accounted for 78%
of all external financing vehicles, which was the lowest proportion of bank loans from 1998 to 2015. Before 2007, this ratio was higher than 90%. Due to this extreme reliance on commercial loans, listed firms and banks are locked in a symbiosis, where each can seriously impact the other.
Within the Chinese banking system, the five largest commercial banks, which hold approximately half of total banking capital, are state owned, so regional and local govern-ments have a great deal of influence in directing bank loans. A recent paper by Z. Zhang, n.d. shows that firms with political connections to banks, especially state-owned enter-prises (SOEs), found it much easier to obtain bank credit during the 2008-09 financial stimulus periods.
Accompanied by the rapid rise of SMEs, which have a high demand for external financing but lack access to formal financial sectors, unequal access to formal finance has resulted in the growth of shadow banking. Defined as financial firms that perform similar functions and assume similar risks to banks, shadow banks comprise a system that generally makes use of a variety of instruments: entrusted loans, loans by trust companies, wealth management products, interbank market activities, etc. (D. Elliott and Qiao, 2015, D. Elliott et al., n.d.).
Among all shadow banking instruments, entrusted loans, a form of loan in which banks act as the trustee in lending out money on behalf of trustors such as government agencies, enterprises and individuals, account for the largest component of shadow banking. Lenders and borrowers negotiate loan terms regarding the loan amount, interest rate and maturity (He et al., 2016). The trustee merely acts as a middleman to facilitate the transaction but does not bear any default risk. As documented by Allen et al., 2019, entrusted loans constituted 32%of shadow banking in terms of RMB value at the end of 2012, and entrusted loans were the second largest source of financing in China in 2013, after bank loans.
Beyond the usual topics in the debate over shadow banking, we are especially curious about the impact of entrusted lending on the banking and corporate sectors. For this reason, we only focus on entrusted loans between enterprises.
Our research questions encompass several aspects: (1) Under what conditions do en-trusted loans arise? (2) What are the characteristics of the firms that become lenders and borrowers of entrusted loans? (3) How is the lending rate determined in entrusted loans, and what is the difference from the formal banking rate? (4) Do firms that provide en-trusted loans operate well in their own businesses? (5) How should policymakers regulate the entrusted loans sector so that loans flows to the firms or industries that need them most?
We first build a theoretical model to address the above questions, and then we examine our model empirically using our data on corporate loans in China.
The model is built on Besanko and Kanatas, 1993b, with firms differentiated in terms of their capitalization, as in Holmstrom and Tirole, 1997. In addition, we eliminate the equity sector and take the banking sector as the only external financing source. The model features moral hazard problems within enterprises; specifically, the probability of success of a firm’s investment project relies on the effort exerted by the entrepreneur who leads it. The bank provides both financing and monitoring services to firms. Monitoring improves the probability of success of an investment but is costly. Shadow banks offer loans but do not provide monitoring unless the borrowers are in the same corporate group or affiliated with the borrower, since in such cases shadow banks’ monitoring costs are smaller than those of traditional banks.
The model shows that shadow lending is a market reaction to increased competitive-ness in the banking sector. Shadow lending arises when the banking sector is completely competitive. When it is not, shadow lending does not exist. The model reveals that shadow creditors are usually large firms with large capitalizations. Since these firms are
able to provide enough collateral to banks and the average monitoring cost of such firms is small, they may overborrow from banks at cheap rates. Afterwards, these firms lend their extra capital to firms, usually SMEs, that can only obtain bank credit at much higher rates.
As mentioned, when the banking sector is completely competitive, banks obtain zero profit, and firms earn all the surplus. The bank lending rate is an increasing and convex function of firm demand. Firms with large capitalizations enjoy a low lending rate; even when credit demand from these firms increases, the marginal lending rate may still be lower than that faced by firms with much smaller capitalizations. Therefore, firms with large capitalizations tend to take advantage of the cheap bank lending rate by overbor-rowing and then lending out the extra financing to firms with smaller capitalizations at a rate that is between the bank lending rates for the two kinds of firms.
Shadow debtors are medium-sized firms. These firms acquire external financing from both traditional banks and shadow banks. Due to the moral hazard problem, shadow banks also base their lending rates on firm capitalization. The shadow rate is an in-creasing function of firm capitalization. Since shadow banks do not provide a monitoring service, the lending rate is smaller than the bank lending rate. However, firms forgo the monitoring service if they substitute traditional banking with shadow banking, which eventually reduces the expected profit of the firm. Therefore, firms must balance the value of the lower lending rate with that of the monitoring service. For firms that acquire shadow financing, demand is a concave function of firm capitalization. For firms with large capitalizations, the difference between the bank lending rate and the shadow rate is too small to compensate for the loss of the monitoring service, so such firms do not take out shadow loans. For firms with low capitalizations, the shadow rate is too high to afford, so these firms do not take out shadow loans.
Shadow lending is beneficial since it improves the profits of the firms involved. Shadow creditors earn extra profit by charging a higher lending rate than bank rate with the capital invested in shadow lending. Shadow debtors save by substituting expensive bank loans with cheaper shadow loans.
That said, an important issue is the moral hazard problem. This work indicates that the presence of shadow lending reduces the probability of success of firms involved in shadow lending. The probability of success is determined by the level of entrepreneurial effort exerted by the firm plus the monitoring effort exerted by the bank. For shadow creditors, the reduction in this probability comes from the drop in the effort exerted by the entrepreneur. Because the shadow creditor requires more bank loans, the return to the entrepreneur who leads the shadow bank is accordingly reduced; thus, the entrepreneur exerts less effort on investment projects, which results in a smaller probability of project success. For the shadow debtor, the reduction in success probability arises from the decreased bank monitoring. Because the firm substitutes part of its external financing with shadow loans, the bank thus receives a lower return from the loan and correspondingly provides the firm with less monitoring.
Thus, on the one hand, entrusted loans offset a deficiency in the banking system by providing a channel to transfer financing from firms that enjoy cheap bank financing to firms that are discriminated against by the banks. This activity is welfare-enhancing.
On the other hand, entrusted loans may discourage banks from providing monitoring services and entrepreneurs from exerting effort. Hence, the moral hazard problem for firms receiving entrusted loans becomes severe and eventually hurts financial stability.
To the best of our knowledge, ours is the first work to offer a theoretical model on
entrusted loans in China. The most closely related paper is that of Allen et al., 2019, in which the authors examine entrusted loans empirically and explain the determination of lending rate from the perspective of fundamental and informational risk. Another related paper is that of He et al., 2016; in this case, the authors focus on the impact of entrusted loan announcements on firm returns, while we focus on the interaction between banks and firms. The paper by K. Chen et al., 2018 also studies the entrusted loan problem in China but focuses on the impact of monetary policy on the shadow lending sector.
Our work is also related to studies of credit rationing. Our model features moral hazard; similar papers include Repullo and Suarez, 2000, Allen et al., 2011, Besanko and Kanatas, 1993b, Holmstrom and Tirole, 1997. Another strand, such as the works by Besanko and Thakor, 1987, Stiglitz and Weiss,1981, focuses on asymmetric information.
Unlike the above papers, we add firm-size heterogeneity and introduce the entrusted loans channel. Therefore, we are able to derive the incentives related to entrusted loans and assess the characteristics of the firms engaged in this activity.
The rest of the chapter is organized as follows. Section 2.2 describes the model and solves the benchmark case in which shadow lending is prohibited. Section 2.3 introduces the shadow lending sector and derives equilibrium bank lending in the presence of shadow lending. Section 2.4 studies bank lending when the banking sector is noncompetitive.
Section2.5 discusses the welfare implications. Section2.6 describes the data, which cover firm loans and measures of shadow-banking activities. Section 2.8 concludes.