Business groups are the most widespread organizational structure in emerging markets (Khanna and Yafeh, 2007), especially in China. After a listed firm borrows a commercial loan from a bank, how it uses the loan becomes a paramount concern. When a listed firm is controlled by a business group, the group has very concentrated share ownership and control rights. Minority shareholders pay close attention to internal transactions between the listed firm and its parent firm or other sibling firms (i.e., subordinate firms under the same parent firm). Engaging in such transactions is called “tunneling”, and it is a source of tremendous expropriation of minority shareholders’ earnings. Given that capital-related tunneling can potentially transfer loans from banks to firms’ related parties, how bank-firm relationships may further impact tunneling activities through the terms of the loan contract between the firm and the bank is the critical question examined in this chapter.
The Chinese banking industry has experienced earth-shaking changes since 2004.
These changes began with the restructuring and IPO of four large Chinese state-owned commercial banks from 2004 to 2008. After an enormous number of city-level commercial bank registrations, mergers and restructurings, since 2008, the Chinese banking indus-try has expanded to disburse massive commercial loans under the 4 trillion RMB fiscal policy. Current innovations include the emergence of e-banking (such as through Ant Financial) and P2P lending. All together, there have been significant changes not only
to the structure of the banking industry but also to the relationships between banks and their borrowers, especially firms holding commercial loans.
In the meantime, the private sector has also experienced enormous changes. To drive economic growth, the Chinese economy has begun to transition towards a market orien-tation. The Chinese government encourages state-owned enterprises to restructure and form business groups (Keister, 1998, White et al., 2008), and private-owned firms also commonly follow this path (Carney et al., 2009). Thus, business groups represent a criti-cal component of the Chinese economy, and most listed firms are part of a business group (Jia et al., 2013b).
During the process of the economic transformation, listed firms have become a capital-raising mechanism for the controlling shareholders. After publicly listing their star sub-sidiary firm, business groups transfer capital either by making intercorporate loans to the majority shareholder or affiliates (G. Jiang et al., 2010a) or by acting as a guarantor of loans to the other group members and assuming liability for repayment of the loans in case of default (G. Jiang et al., 2010a, Fisman and Wang, 2010). These tunneling behaviors among member firms of the same business group are pervasive in China (Keister, 1998, Keister, 2001). The China Security Regulatory Committee (CSRC) now requires listed firms to publicly reveal in detail all transactions with related parties, including loans, guarantees, and operations, which allows for the analysis of tunneling behaviors at the transactional level.
As the two sectors have experienced enormous changes at the same time, the con-nection between the banking sector and industry firms has become more substantial and complicated. In the Chinese market, banks are the ultimate supplier of enormous financ-ing resources to industry firms. In contrast to the prediction of traditional peckfinanc-ing-order theory (Myers and Majluf, 1984), banks always occupy the position of top external fi-nancing channel of Chinese listed firms. By aggregating three external fifi-nancing cash flows of Chinese listed firms across years, figure A.1illustrates that the value of corporate bonds and new shares issued in the Chinese market is very small compared with that of commercial loans from banks. In 2015, the total amount of newly issued commercial loans to all listed firms was more than 6 trillion yuan and accounted for 78% of all external financing vehicles, which is the lowest proportion of bank loans from 1998 to 2015. Before 2007, this ratio was more than 90%. Due to this extreme reliance on commercial loans, there is a symbiosis between listed firms and banks, where one can severely impact the other.
Against this background, it becomes meaningful to investigate bank-firm relationships and how they impacts borrowers’ tunneling activities.
There are different views in the literature on tunneling activities and the role that strong bank-firm relationships play in them. On the one hand, if a strong bank-firm relationship can help a listed firm sign an advantageous contract, a business group can transfer more capital out of the listed subordinate. The transferred funding can benefit other organizations within the same business group, a behavior that Johnson et al.,2000 defines as “tunneling”. Based on agency theory, many studies characterize this behavior as expropriation of the returns of minority shareholders and identify similar activities in different countries, e.g., Bae et al.,2002 in Korea, Bertrand et al.,2002in India, G. Jiang et al., 2010ain China, and Morck et al.,2005in Japan. Alternatively, the listed firm may act as a guarantor to help its sibling firms receive bank loans, which the listed firm will pay back the debt if the sibling firm goes into default. From the study of Scharfstein and Stein, 2000, when the different divisions or subsidiaries under the same firm or a business
group and, more importantly, when they have different strength, e.g., the listed firm is the star of the business group, the massive inefficiencies are very likely to arise through the internal capital market. The strong subsidiary company will subsidize the weak ones in many ways, such as the tunneling approach.
On the other hand, Dass and Massa, 2011 demonstrates that a stronger bank-firm relationship pushes banks to govern misbehaviors in corporations, such as tunneling ac-tivities. If banks are aware of tunneling activities, they are assumed to take measures to protect their assets to avoid an increased probability of default risk. A stronger bank-firm relationship could allow the bank access to inside information to improve its capital allo-cation and enhance its monitoring capability (e.g., Diamond,1984, James, 1987, Besanko and Kanatas, 1993a), while strengthening the listed firm’s corporate governance (Levine, 2002).
In addition to the positive and negative impacts of tunneling, Jia et al.,2013bbrings up coinsurance theory to demonstrate that tunneling activities can be bidirectional. That is, they can boost the capital of the business group but can also save the listed firm. However, it is unknown how bank-firm relationships impact tunneling behaviors and directions in different situations.
Therefore, this chapter aims to study how bank-firm relationships impact listed firms’
tunneling activities under different circumstances in the Chinese market.
Although complete related-party transactions are available for listed firms, to execute this analysis, we also requires a measurement of the strength of a bank-firm relationship.
The literature provides two variables as proxies: the proximity between the lending bank and the firm and the availability of insider information to the bank as one of the firm’s top shareholders (Dass and Massa, 2011). Proximity is defined as the geographical distance between the borrowing firm and the lending bank, which is associated with the bank’s information-gathering capability (Coval and Moskowitz, 2001, Berger et al., 2005). The equity exposure measure considers the extent of bank access to inside information and is calculated as the direct equity ownership stake of the lending bank in the borrowing firm, which is the fraction of the borrower’s equity held by the investment fund of the lending bank (Kahn and Winton, 1998).
Constructing the measurements of the bank-firm relationship requires a massive col-lection of banking information and loan-level data on all listed firms. However, this task is difficult given the incomplete character of the Chinese finance data system. The au-thor designed an algorithm to extract a dataset with information on commercial loans by analyzing the text of annual financial reports. This dataset contains details on the characteristics of bank loans made to a broad panel of firms in China from 2001 to 2015, including bank names with branches, amount, duration, interest rates, and collaterals if reported. By merging this unique dataset with the financial statements of listed firms and the information on bank branches, I can calculate both the proximity and equity exposure measurements.
With the bank-firm relationship variables and related-party transaction observations, the study of their relationship must address two potential biases: selection bias and the endogeneity of the bank-firm relationship proxies. To solve these issues, this chapter ap-plies the lambda from the Heckman model to correct for selection bias. It introduces instrumental variables to address the endogeneity issue via the 2SLS model. After ex-cluding the possibility of the results being affected by these biases, this chapter illustrates that a close bank-firm relationship can help to mitigate tunneling activities in all perspec-tives, including direct capital lending by the borrowing firm, and other noncash tunneling
activities, such as trading business goods with related parties and acting as the guarantor of a related firm with another bank as different as the lending bank of the listed firm.
The analysis is not complete if it only looks at the direct relationship between bank-firm relationship (BFR) and related-party transaction (RPT) without studying the chan-nel and causal mechanism of the effect. The in-depth analysis considers two chanchan-nels through which the bank-firm relationship impacts the borrower’s tunneling activity. The classical mechanism is the terms of the loan contract. Proximity and equity exposure can impact the loan contract in different ways, such as by reducing the lending amount and tenor and increasing interest rates. On the other hand, a stronger bank-firm relationship can also strengthen the corporate governance of the borrowing firm, which is reflected in a reduced prevalence of directors sitting on multiple boards across firms, an increased percentage of independent directors and an improved probability of having a nonexecu-tive chair. All these indicators show a significant improvement in corporate governance quality alongside the reduction in tunneling activities.
Last but not least, given the coinsurance theory, it is necessary to test whether the av-erage effect of the bank-firm relationship on related-party transactions holds in particular situations. When the ultimate controller of the listed firm faces severe financial difficulties and its controlling shares are used as collateral, a stronger bank-firm relationship helps prevent tunneling towards the parent firm. On the other hand, when a listed firm faces the risk of being delisted due to two consecutive years of negative profits, the lending bank reduces the strictness of its monitoring of internal transactions to protect the firm’s listed position on the stock market.
This chapter makes several contributions. First, it represents the first attempt, to the author’s knowledge, to quantify the bank-firm relationship in China. Second, it shows how banks can impact a firm’s internal tunneling activities and sheds some light on corporate and shadow-banking governance through the bank-lending channel. The remainder of the chapter is structured as follows. Section 2 introduces the hypothesis. Combining the econometric methodology described in section 3 and the data source discussed in section 4, the chapter constructs the critical variables and offers preliminary estimations. Section 5 reports the main findings and discusses the channel of the effect. Furthermore, section 6 provides a supplementary analysis to study the different facets of the main findings in particular situations. Conclusions and potential future research are presented in the final section.