Delegated monitoring in a multiple-principals agency relationship

The model above presents an agency relationship where the bank is the single principal. In this agency relationship, banks alone obtain the benefits from the improved monitoring of borrowers.

However, in a real case scenario, banks are not the only principals of a borrower.⁹⁸⁴ A single borrower may have many principals in the same time, whose claims vary in size as well as in maturity. This is the case for example when a firm engages with multiple lenders or when it borrows from a bank and in the same time borrows through contracting with other third party creditors, such as suppliers, employers, etc., for other services or goods. In these scenarios free-riding problems are widespread and could affect the quality of monitoring by banks, as the benefits from qualitative monitoring accrue to all creditors, whereas the costs are primarily borne by banks. For the purposes of understanding the role of banks as delegated monitors also in these cases, it is important to look into the incentives of banks to monitor a borrower in the presence of additional principals.

1. “One bank, several third party creditors” scenario

In such a scenario, a debtor firm has a borrowing relationship with a single bank, and in the same time it maintains various contractual relations with third party creditors, most typically with various suppliers of goods and services, and certainly with employees. In this type of creditors’

constellation, banks are typically larger creditors holding claims that are large in size⁹⁸⁵ and often longer in maturity.⁹⁸⁶ Because of these characteristics, banks are frequently secured creditors, i.e. they obtain collateral or security interests as a means to ensure the repayment of the loan.

According to Levmore, it is the holding of security interests on the debtor’s assets that helps banks to mitigate free-riding problems related to the monitoring of the debtor firm.⁹⁸⁷ Especially smaller creditors who own claims that are comparably small to bank’s claims face strong free-riding problems, because the size of their claims does not justify the monitoring costs. Therefore, these smaller creditors prefer to rely on the monitoring of larger creditors, such as banks. As secured creditors, bank’s interests are directly connected to the availability and quality of the debtor’s assets and therefore they are incentivized to monitor the firm’s assets, although the benefits from such monitoring accrue as a matter of fact to all the creditors,⁹⁸⁸ including those

984 Kahn/Mookherjee, RAND Journal of Economics, 1998, 443, p. 443.

985 Compared to claims held by suppliers.

986 Although this is not always the case. For example, retirement claims held by employees are normally longer in maturity than bank loans.

987 Levmore, Yale Law Journal, 1982, 49, p. 56.

988 For example, all the creditors of a debtor firm benefit from a reduction in the overall insolvency risk of the firm.

creditors who do not expend efforts to monitor. In this way, banks perform delegated monitoring on behalf of third party creditors too, although the delegation is implicit rather than explicit.

However, it would be exaggerated to point here to an altruistic behaviour of banks in performing delegated monitoring also for third party creditors, despite the fact that also the latter benefit from such monitoring. The lack of altruism by banks in providing monitoring is most probably to be observed in the quality of the monitoring that banks provide. Simply the fact that banks have an incentive to monitor the debtor does not necessarily warrant for a qualitative monitoring that would benefit all creditors, despite the fact that banks appear to be qualified monitors, as they possess financial expertise, are experienced in financial transactions and enjoy economies of scale in producing information needed for monitoring.⁹⁸⁹ Simply the freedom from free-riding problems may not provide an incentive sufficiently strong for banks to perform quality monitoring.⁹⁹⁰

Nevertheless, as a summary, it can be said that even in the presence of several principals acting as creditors of a borrower, banks as major principals have incentives to monitor the borrower.

Bank’s financial interests in the borrower are usually sufficiently large to overcome free-riding temptations and to warrant borrower monitoring, despite the possibility that benefits from such monitoring will accrue to the remaining creditors who are not willing to expend resources for adequate debtor monitoring.

2. “Several banks, several third party creditors” scenario

Under this scenario, the debtor firm has multiple lending relations with several banks, and in the same time maintains contractual relations with various third party creditors as in the previous scenario. Third party creditors are left out of the analysis in this scenario, because it is assumed that they, as in the previous scenario, benefit from the monitoring carried out by banks. In this second scenario, it is particularly relevant to understand whether, and if yes, how banks coordinate with one another to monitor the debtor firm, assuming that they are all secured creditors. It seems fairly reasonable to suggest that also in this constellation of creditors, free-riding is widespread, not only among unsecured creditors, but also among the secured ones.⁹⁹¹ While unsecured creditors ride on the monitoring by secured creditors, the issue of free-riding among secured creditors can create suboptimal results with regard to debtor monitoring

989 Levmore, Yale Law Journal, 1982, 49, p. 56.

990 See also the arguments by Levmore regarding the incentives of secured creditors to monitor. Levmore, Yale Law Journal, 1982, 49, p. 57.

991 Ibid., p. 68 ff. See also Rajan/Winton, Journal of Finance, 1995, 1113, p. 1114.

due to coordination problems. The creditor doing the monitoring has fewer incentives to acquire and use additional information because he does not get the added benefits from such monitoring.⁹⁹² In multiple lenders scenarios, coordination problems among lenders become more acute when the borrower is facing financial distress.⁹⁹³ Therefore, free-riding causing coordination problems⁹⁹⁴ among creditors need to be tackled in order to avoid that no monitoring occurs at all in the worst case. Levmore suggests as an option for resolving free-riding issues among creditors the allocation to each creditor of an asset of the debtor as collateral. In this way, a creditor would not have other creditors having security interests in the same collateral, and therefore there would be no temptation to freeride on monitoring.⁹⁹⁵ Each creditor would monitor its “own” asset, and as a result, the debtor firm as a whole would be monitored. Additionally, by allocating collateral as well as seniority among the secured creditors, a run on the borrower’s assets is avoided when the borrower faces financial distress.⁹⁹⁶ This proposal would supposedly solve coordination problems among creditors when borrower is experiencing financial distress or is approaching insolvency since it gives to the most senior secured creditors the incentive to monitor the distressed borrower in terms of deciding whether to renegotiate the debt or let her go insolvent.

However, this solution has its own limitations that directly affect lenders’ incentive to monitor the borrower. Thus, when the value of the collateral remains unaffected after the borrower has been funded, then the lender sees no need to investigate borrower’ financial position before the funding occurs.⁹⁹⁷ Moreover, a fully collateralized lender faces a moral hazard since he is immunized from the actions of the borrower, no matter how opportunistic they may be, and thus has no incentive to monitor the borrower after the funding occurs.⁹⁹⁸ Both kinds of bank behaviours may have negative consequences on the financial stability of the bank.

992 Rajan/Winton, Journal of Finance, 1995, 1113, p. 1114.

993 Elsas/Krahnen, Center for Financial Studies Working Papers, 2002, 1, p. 1.

994 Rajan/Winton, Journal of Finance, 1995, 1113, p. 1127.

995 Levmore, Yale Law Journal, 1982, 49. See also study by Cerqueiro/Ongena/Roszbach, Sveriges

Riksbank Working Paper Series No. 257, 2012, Available at

http://www.riksbank.se/Documents/Rapporter/Working_papers/2012/rap_wp257_120224.pdf, finding that collateral is important for the bank and valuable for the borrower, and that banks holding collateral preserve their incentives to monitor borrowers.

996 Elsas/Krahnen, Center for Financial Studies Working Papers, 2002, 1, p. 1.

997 Niinimäki, Helsinki Center for Economic Research Discussion Papers, 2007, Available at http://ethesis.helsinki.fi/julkaisut/eri/hecer/disc/181/doescoll.pdf, p. 1.

998 Rajan/Winton, Journal of Finance, 1995, 1113, p. 1136. See also Niinimäki, Helsinki Center for

Economic Research Discussion Papers, 2007, Available at

http://ethesis.helsinki.fi/julkaisut/eri/hecer/disc/181/doescoll.pdf, p. 16.

Furthermore, the allocation of collateral as an incentivizing mechanism to lenders would solve monitoring problems mainly when the firm’s assets allocated as collateral are crucial⁹⁹⁹ to the firm, i.e. they are crucial to the business of the firm and their performance provides important information or signals about the financial stability of the debtor. Additionally, assigning collaterals to secured creditors to mitigate free-riding problems would not solve satisfactorily coordination problems among the secured creditors. More specifically, a secured creditor, while monitoring the assigned asset, may gain important information about the financial stability of the firm, which is not known to other creditors, and may want to use this information to extract additional advantages or benefits from the debtor firm. In another case, in the course of monitoring, the creditor might obtain crucial information regarding imminent financial distress to be faced by the debtor firm and as a result might take steps to liquidate its claim or reduce exposure before the debtor is actually hit by financial difficulties and the value of its assets decrease. It becomes thus obvious that monitoring also by secured creditors can be used for self-serving purposes to secure own interests, even if that would mean that other creditors would suffer losses.

This example points to another limitation of the model when monitoring is delegated to secured creditors, namely how monitoring-relevant information is disseminated to other principals in a multi-principal agency relation. Literature on delegated monitoring and agency problems¹⁰⁰⁰ points often to the fact that when monitoring is delegated, the delegated party collects private information about the debtor firm, which he is not willing to share with others.¹⁰⁰¹ This is often the case especially when the creditor wants to avoid losing a good debtor to a competitor.¹⁰⁰² Moreover, private debtor information helps banks to strengthen lending relationships with borrowers as it improves lender’s control over the borrower and reduces overall monitoring costs.¹⁰⁰³ Bearing these considerations in mind, one is not surprised if banks as delegated

999 “Focal points”. See Levmore, Yale Law Journal, 1982, 49, at p. 58.

1000 See Harris/Raviv, Journal of Economic Theory, 1979, 231; Holmström, Bell Journal of Economics, 1979, 74; Shavell, Bell Journal of Economics, 1979, 55, and also Leland/Pyle, Journal of Finance, 1977, 371; Chan, Journal of Finance, 1983, 1543; Diamond, Review of Economic Studies, 1984, 393, Journal of Political Economy, 1991, 689, FRBR Economic Quarterly, 1996, 51; Boot, Journal of Financial Intermediation, 2000, 7.

1001 Diamond, FRBR Economic Quarterly, 1996, 51, p. 55. See also Diamond, Review of Economic Studies, 1984, 393.

1002 Petersen/Rajan, Journal of Finance, 1994, 3, p. 36. See also Fischer, Hausbankbeziehungen als Instrument der Bindung zwischen Banken und Unternehmen: eine theoretische und empirische Analyse, 1990.

1003 The concept of “relationship banking” is not clearly defined in literature, but various authors agree that such relationship is not limited simply to bank lending, but it includes also the provision of other financial services by the bank to the lender, especially of information intensive services. Thus, two important elements in a “relationship banking” are proprietary borrower’s information that goes beyond

monitors prefer to be sole creditors/principals in a lending relationship, instead of “sharing” the borrower with other banks.¹⁰⁰⁴ Maintaining a close lending relationship with the borrower helps lenders to reduce overall lending costs, including monitoring costs, and provides them with information monopoly which they can use to their advantage,¹⁰⁰⁵ for instance by charging higher interest rates. In the presence of multiple banking relationships, the value of borrower’s proprietary information that each bank holds reduces, and as a result lending relationships become less attractive and benefiting for banks.¹⁰⁰⁶ As a result, monitoring incentives might reduce as well.

As a summary, it can be said that also in the presence of several banks as principals, banks as secured creditors have incentives to monitor the debtor, but the monitoring may be limited to the performance of the asset they hold as collateral,¹⁰⁰⁷ especially when that collateral is a focal asset and the value of the collateral is stable over time and sufficiently high to satisfy the claims of the bank in case of debtor’s default. Secured creditors use collateral not only as a means to hedge against risk of default, but also as a mechanism to strengthen their bargaining power during debt contract’s renegotiations when the borrower is facing financial distress.¹⁰⁰⁸ Monitoring may be fragmented and coordination problems among creditors may lead to suboptimal results. When monitoring is conducted, it is useful to the banks performing it, but not necessarily to other secured or non-secured creditors. When a strong creditor chooses to take actions to discipline the borrower, there is no guarantee that the results will be optimal for the other creditors as well.¹⁰⁰⁹

Additionally, when a debtor maintains multiple banking relationships, lender-borrower ties become weaker as banks perceive the gathering and producing of borrower’s private information as too costly relative to its uses. If lending relationships are short and rather transaction-oriented,

what is available publicly and multiple interactions between the borrower and the lender.

Petersen/Rajan, Journal of Finance, 1994, 3, p. 34; Boot, Journal of Financial Intermediation, 2000, 7, pp. 7-11. See also Ramakrishnan/Thakor, Review of Economic Studies, 1984, 415; Rajan/Winton, Journal of Finance, 1995, 1113, and Diamond, Review of Economic Studies, 1984, 393.

1004 However, see also arguments by Carletti/Cerasi/Daltung, Center for Financial Studies Working Papers, 2004, 1, on the benefits to banks to engage in multiple-lending as a way to improve diversification.

1005 Petersen/Rajan, Journal of Finance, 1994, 3, p. 35.

1006 Boot, Journal of Financial Intermediation, 2000, 7, p. 21. See also Cole, Journal of Banking and Finance, 1998, 959, and Chan/Greenbaum/Thakor, Journal of Banking and Finance, 1986, 243.

1007 Levmore, Yale Law Journal, 1982, 49.

1008 Elsas/Krahnen, Center for Financial Studies Working Papers, 2002, 1, p. 33-35. Bargaining positions of creditors are especially strong when the collateral held by the bank is highly liquid.

1009 Elsas/Krahnen, Center for Financial Studies Working Papers, 2002, 1, p. 35.

banks may find it less worthwhile to acquire costly proprietary information by “getting to know”

the borrower.¹⁰¹⁰ As a result, it could be expected that banks would do more of a limited debtor monitoring for private reasons,¹⁰¹¹ than a delegated monitoring, the benefits of which would accrue to third party creditors as well.