Should banks own equity? A corporate finance perspective

Mahrt-Smith, J (2000) Should banks own equity? A corporate finance perspective. Working Paper. London Business School IFA Working Paper FIN314.

Abstract

This paper examines the question whether banks should hold a share of their borrowing firms' equity. A bank's equity participation can help overcome a well documented agency problem: without the equity participation, the bank would use its informational advantage over other sources of finance (e.g. competing banks) to extract profits from the client firm whenever the firm needs additional investment funds. This, in turn, reduces the incentives of the borrowing firm to generate profits. It is shown that even a small, minority equity stake held by the bank significantly reduces the propensity of the bank to extract profits, which then improves the incentives of the firm. A small equity stake suffices, because the private information that the bank has about the firm makes the bank's profit extraction extremely sensitive to the nature of the bank's claim. The benefit of bank equity participation is related to firm characteristics (e.g. size, growth, capital needs, etc.), characteristics of the banking sector (e.g. competition), as well as information issues (e.g. the quality of the prevailing accounting practices). The paper addresses, from a corporate finance perspective, the current debate about whether banks should be allowed to own equity stakes, and if yes how large these should be.