Bank Equity Stakes in Borrowing Firms and Financial Distresses

Abstract

In this paper we examine a model of the optimal financial claim for a bank in a world where a borrowing firm’s uninformed stakeholders depend upon the bank for truthful information about the firm’s evolving financial condition. In particular, stakeholders rely upon the bank to reveal whether the borrowing firm is truly financially distressed and whether concession by stakeholders are necessary. The bank’s financial claim is designed to ensure that it cannot form a coalition with the firm’s owners either to seek unnecessary concession when the firm is actually healthy, or to claim that the firm is healthy when it is actually in distress.

We show that the optimal chain has the following characteristics. To ensure that a healthy firm/bank coalition will not form to seek unnecessary concessions from stakeholders, the bank must keep its equity stake in a distressed firm below a ceiling level. To ensure that a distressed firm/bank coalition will not falsely claim that the firm is healthy, a sufficiently large portion of the bank’s financial claim on the healthy firm must be subordinated to stakeholders’ claims. Since banks may have difficulty in credibly subordinating their debt claims, a bank equity stake in the healthy firm may be necessary. Thus, our analysis offers limited support for the argument that bank equity stakes in borrowing firms may enhance banks’ ability to reduce the costs of financial distress for borrowing firms.