The effects of the bank holding equity of the firm: from a moral hazard perspective

Abstract

After the repeal of the Glass-Steagall Act in 1999, commercial banks are allowed to hold equity in firms. The current financial crisis also helps make banks universal in the US. This paper investigates the effects of the bank’s equity holding of the firm from a moral hazard perspective. The bank’s equity holding of the firm is shown to help mitigate the conflicts between the firm’s shareholders and debtholders. However, it also creates another moral hazard problem, namely, the bank as an institutional shareholder can collude with the firm manager to pursue perks from project return. Without this moral hazard problem, the bank’s optimal equity holding of the firm is shown to be at the point where its share of the firm’s equity equals its share of the firm’s debt. With this moral hazard problem being taken into consideration, the bank’s optimal equity holding should be less than its debt share in the firm. Otherwise, the bank will force the firm to pursue overly risky projects. If asymmetric information is introduced into the model, the bank’s equity holding becomes a signal to the outside debtholders, thus should be capped above by a certain level. Thus, the paper shows that regulations still need to be imposed on banks’ equity holding in firms.