Bank loans and corporate debt ownership: some evidence from an economy in transition.

Rajagopal, Sanjay

INTRODUCTION

Theoretical and empirical work in finance indicates that firms weigh the costs and benefits of private debt financing, and arrive at an optimal mix of private ("inside") and public ("arms-length") debt (e.g., Rajan, 1992; Diamond, 1993; Houston & James, 1996; Johnson, 1997a). In particular, the evidence suggests that, among other factors, the degree of information asymmetry and monitoring need exhibited by a firm affects the relative weights of the two types of debt in the firm's financing structure, since private debt tends to mitigate the adverse selection and moral hazard problems that accompany external financing.

Some of the existing models, however, single out banks rather than other private lenders as being uniquely positioned to produce ex-ante information and/or provide ex-post monitoring (Diamond, 1984; Fama, 1985). Several empirical studies also lend support to the argument that banks are "special" in this regard (James 1987; Lummer & McConnell, 1989; Hull & Moellenberndt, 1994). If bank debt is more effective than non-bank private debt in overcoming problems of adverse selection and moral hazard, then studies of the ownership structure of corporate debt should distinguish between the two sources of private financing.

While a few existing studies, notably Houston & James, 1996, and Johnson, 1997a, 1997b, make this distinction, filing requirements for U.S. firms--their population of interest--preclude the possibility of measuring total bank debt. For these firms, only long-term bank debt can directly be measured. Yet, in some models, costs to bank financing, such as a distortion of investment incentives and suboptimal liquidation, stem from short-term bank loans (Rajan, 1992; Diamond, 1991).

The present paper contributes to the study of the ownership structure of corporate debt by examining the cross-sectional regularity in the use of private, bank, and non-bank private debt among Indian firms. The available data for these firms permits the use of both short-term and long-term bank debt in the empirical treatment of the subject. Furthermore, the Indian context is an interesting one because its banking sector, traditionally monopolized by the state, has seen significant (though not complete) privatization, has acquired some transparency, and has increasingly been exposed to market discipline. The process of reform in India has certainly not brought its financial system yet to the levels of competition, efficiency and relative transparency found in developed countries (see indications of this in, for example, the Guha-Khasnobis & Bhaduri, 2000, study). This paper asks whether banks and other private lenders, in this state of the country's "partial adjustment" towards a competitive financial system, play a monitoring role similar to the one observed in the U.S. The study's findings are potentially significant in assessing the progress the country has said to have achieved in the reform of its financial sector.

A final distinguishing feature of the present study is that it incorporates information from the equity ownership structure of the firm. Specifically, it considers the influence of banks' equity stake in the company on the firm's preference for bank financing. The inclusion of this variable is motivated by the Rajan, 1992, model, in which the preference for bank debt (and bank debt maturity) is influenced by the firm's bargaining power with the bank. A suggested proxy for this bargaining power is the bank's equity position in the firm, a piece of information which is unavailable for U.S. firms. Even though the proxy used in the present study is an approximation, its inclusion represents a useful increment in the direction of empirically examining a hitherto untested proposition.

The paper is organized as follows. The section below reviews the literature on the firm's private/public debt choice, and on the special role of bank financing. The next section provides an overview of recent financial sector reforms in India. Following that, the data and variables used in the study are discussed, and the criteria for sample selection described. This section also provides a discussion of the hypothesized relationships. Next, regression results pertaining to private, bank, and non-bank private debt usage are reported and discussed. The final section carries the conclusions and implications of the study, along with suggestions for further research.

BANKS, FIRM ATTRIBUTES, AND THE MIX OF LENDERS

Over the last decade, a segment of financial research has hypothesized and documented a systematic link between firm-level characteristics and the corporation's placement choice of debt. Much of the work has demonstrated a unique role for lenders in the private debt market. This special role is argued partly to stem from a more concentrated ownership of private debt which reduces free-rider problems and makes information production and monitoring more economically feasible than in the case of diffusely held public debt (Diamond, 1984; Berlin & Loeys, 1988; Diamond, 1991; Easterwood & Kadapakkam, 1991). Typically, there is also a greater flexibility to the renegotiation of contract terms in the case of private debt. The superior ex-ante information among those with a private claim, and their greater control over the borrower's investment and liquidation decisions mitigates the problems of adverse selection and moral hazard associated with credit generation (see, for example, Smith & Warner, 1979; Diamond, 1984; Blackwell & Kidwell, 1988; Berlin & Loeys, 1988). However, there are also costs to private debt in the form of monitoring costs, bank regulatory taxes, premiums for reduced liquidity, and agency costs of delegated monitoring (Zwick, 1980; Berlin & Loeys, 1988; Diamond, 1991). The tradeoff of benefits and costs, in turn, argues the existence of an "optimal" level of private debt. This line of reasoning suggests that for firms with larger information asymmetries and greater monitoring need, the benefits of private debt will, ceteris paribus, tend to outweigh the costs of private lender monitoring.

Several studies examine the precise factors affecting a firm's choice of public versus private debt (e.g., Diamond, 1991; Rajan 1992; Diamond 1993; Houston & James, 1996; Johnson 1997a; Krishnaswami et al., 1999). The Diamond, 1991, study stresses a "reputational capital" effect in the debt source choice, wherein larger firms, with established reputations (at stake) are more likely to access the public debt market since they do not need to rely now on the monitoring role of banks. The study by Rajan, 1992, stresses possible "hold up" problems when firms borrow from a single bank (which might have an informational monopoly), which makes reliance on bank debt less likely for firms with high quality projects. In contrast, in Yosha, 1995, firms with high quality projects avoid public debt so as to conceal sensitive information and preclude competitive responses from rivals.

Some models focus on considerations of efficiency in liquidation, and the impact of these concerns on the choice of debt source (e.g., Berlin & Loeys, 1988; Berlin & Mester, 1992). These argue that firms with projects of low liquidation value--for whom early liquidation would therefore be onerous--will tend to avoid bank or other private debt because they have harsher covenants than public debt; covenants are harsher since renegotiation is easier.

Linking a firm's chance of distress to the value it places on forestalling liquidation, Chemmanur & Fulghieri, 1994, suggest that riskier firms will be attracted to bank financing since such debt is more easily renegotiated; safer firms, who do not require this contract feature, will lean towards public debt and avoid pooling. One of the predictions of the Hoshi, Kashyap & Scharfstein, 1993, model--which focuses on managers' investment behavior--is that firms with lower leverage use public debt because their higher equity-at-risk constrains inefficient investment. Greater collateral-at-risk performs a similar bonding function, so firms with more valuable assets-in-place will employ public debt. More assets-in-place implies a smaller potential for asset substitution problems, and a lesser need for monitoring (Johnson, 1997a).

Easterwood & Kadapakkam, 1991, study the effect of transactions costs and leverage-related costs on the private/public debt choice, and find that larger firms, with their larger issue sizes, save on transactions costs (the large "fixed" cost portion being spread over a large issue size), and tend to lean on public debt more than do medium-sized firms. While it is their conjecture that information asymmetry are also likely to be important to the private/public debt choice, they do not directly test this proposition. Houston & James, 1996, find evidence consistent with Rajan's, 1992, "hold up" problems model, a problem mitigated by establishing multiple-banking relationships. Johnson, 1997a, finds that firms have a greater reliance on public debt if they face lower information and monitoring costs. Krishnaswami et al., 1999, also find evidence consistent with the hypothesis that younger firms, and those with greater potential information asymmetries, will tend to rely on private debt.

While the aforementioned information-production and monitoring benefits are attributable to private borrowing in general, some models single out banks as having a comparative advantage in information gathering and ex-post monitoring (e.g., Myers, 1977; Fama, 1985). It is argued that the deposit-taking function of banks allows them a degree of monitoring not available to other private lenders. Banks possibly are more efficient at screening and monitoring on account of a repeated generation of varied loans over time.

Several studies provide empirical evidence of a special monitoring role for banks (e.g., James, 1987; Lummer & McConnell, 1989; Slovin & Young, 1990; Hull & Moellenberndt, 1994; Johnson, 1997a; Johnson, 1997b). While most security offerings elicit a negative or neutral stock market response, James, 1987 and Lummer & McConnell, 1989, show that the market reacts positively to new bank loans and renewals of existing lending arrangements. Slovin & Young, 1990, provide evidence that IPO under-pricing is mitigated by the use of bank debt. Hull & Moellenberndt, 1994, find that the negative stock market response to equity issues is more severe when the proceeds are intended for the retirement of bank debt. Johnson, 1997a, finds that (long-term) bank debt use and non-bank private debt use are related in opposite ways to three firm-level attributes, namely, leverage, the fixed asset ratio, and the market-to-book ratio. In Johnson, 1997b, bank debt increases optimal firm leverage.

In summary, several models hypothesize cross-sectional regularities in the mix of private and debt, and extant research documents these patterns among U.S. firms. Information asymmetry, potential asset substitution problems and monitoring need, concerns of inefficient liquidation, and leverage appear to be among the factors that affect significantly the tradeoff between the costs and benefits of privately negotiated financing. There is also evidence that banks in particular possess a special information-production and monitoring role, so that a study of the ownership structure of corporate debt ought to distinguish between bank financing and other private debt. Few studies distinguish between bank and non-bank private debt in their empirical analysis because of data availability issues. The couple of studies that make the distinction must limit themselves to a study of long-term bank debt, since total bank data is unavailable for U.S. firms. The present study proposes

to extend the study of debt placement by incorporating total bank debt (short-term and long-term), and by focusing on an emerging ("bank-oriented") economy, India, which has experienced substantial financial sector reform over the last decade. The following section describes the reform process in that country.

REFORM OF THE INDIAN FINANCIAL SECTOR

Financial sector reform has been an integral part of the new economic policy adopted by India beginning in 1991 (see, for example, Guha-Khasnobis & Bhaduri, 2000). This process of financial reform has entailed, among other things, a significant reduction in the cash reserve requirement (CRR) and the statutory liquidity ratio (SLR). Between 1991 and 1998, for instance, the SLR declined from 38.5% to 25%, and the CRR has declined from about 25% to 10.5% (for a more detailed discussion of the reforms, see Ahluwalia, 1999; Beim & Calomiris, 2001; and Laeven, 2003, from which much of the discussion in this section is adapted, and which are also the source for the data quoted here). Thus, the proportion of incremental resources to banks (from deposits) that was pre-empted by the government was roughly 65% prior to the reforms; that number now stands at about 36%. Put another way, the "tax" on financial intermediation has significantly been reduced over the 1990s.

Interest rate controls have also been eased progressively, moving the loan market away from a regime of subsidized rates and towards a more rational, market-based system. Banks are relatively freer to price loans on the basis of fund costs and credit risk. The easing of entry restrictions to a traditionally state-controlled banking sector, which occurred in 1993, is reflected in the fact that between 1991 and 1997, the market share of private and foreign banks increased from roughly 11% to approximately 18%. Another significant development has been the introduction of capital adequacy standards for banks. Prudential norms somewhat similar to the ones recommended by the Basle Committee were phased in by 1996, which, in addition to lending some transparency to the balance sheets of banks, lean on the institutions to improve asset quality. Bank supervision has also been strengthened, with the establishment of the Board for Financial Supervision within the Reserve Bank of India (RBI), India's central bank. The role of internal controls and audit, and that of external auditors have been shored up, and the time taken for the inspection and follow-up cycle has been cut in half.

Despite the improvements described above, though, the question which is of particular relevance to the current paper is how the new, reformed standards compare with international practice. As Ahluwalia, 1999, notes, the government-appointed Committee on Banking Sector Reforms (CBSR) has reported several deficiencies with regard to the comparability of the new Indian banking norms with international standards. For instance, capital-to-risk-weighted-assets for banks continue to be below international standards. Indian standards are more lax with regard to the reclassification of "substandard" and "doubtful" assets; a greater period of delinquency is allowed by Indian banks before such assets are downgraded. "Directed credit policies", which require banks to earmark 40% of their commercial loans to "priority" sectors identified by the government, remain in place. Significantly, the government still maintains a majority ownership of public sector banks (which account for a significant share of the market). This public ownership "involves 'politicization' and 'bureaucratization' of banking" (Ahluwalia, 1999, p.44). Thus, it is quite possible that Indian banks, despite the recent progress in liberalization, are beset by "cronyism" in loan making, and an impaired ability to respond to commercial and customer needs (or dictates of the market).

It is this "transitional" nature of the Indian financial sector that provides the context for the current paper, and motivates the question as to whether the determinants of (a) the private/public debt choice, and (b) the bank-versus-non-bank private debt choice, identified for firms in developed economies also play a significant explanatory role in India. For example, if banks are operating in an environment divorced from the pressures of the market, are making credit decisions not on the basis of a rational assessment of risk but for the sake of political expediency, and have little incentive to monitor the borrower, or generate information that is economically valuable to loan making, then the role of firm attributes, such as information asymmetry, leverage, or growth opportunities, might not be significant factors in the Indian context, while they appear to be relevant to the private/public debt choice among U.S. firms. Put another way, if private lending practices are not "fair" and "economically rational", then we are unlikely to observe economically sensible patterns in the private/public debt choice or the use of bank financing among Indian firms. The expected patterns in private and bank debt use are described in the next section.

DATA, VARIABLES, METHOD, AND HYPOTHESIZED RELATIONSHIPS

The data used in this study are collected from a publicly available database compiled by the Center for Monitoring the Indian Economy (CMIE). This dataset provides a comprehensive coverage of firms operating in India's industrial sector, and carries substantial financial statement information and some market data. All the income statement data in this study pertain to the year ending December 2002, and all the balance sheet information is as of December 31, 2002. Market data are averaged over the 365 days ending December 31, 2002.

In order to enter the sample, a firm had to meet the criteria listed below. The four restrictions yield a sample of 303 firms for Models 1, 3, and 5, and 266 firms for Models 2, 4, and 6 shown in Tables 1 and 2.

Criteria for Entry into the Sample

1. The firm is categorized as a manufacturing firm in the CMIE dataset.

2. The firm is publicly traded.

3. The firm has public, bank, and non-bank private debt in its capital structure.

4. There is firm-specific data available on the variables of interest for the time period considered.

This study employs the ten variables listed below. The first three are alternatively used as regressands, while the remaining seven enter as explanatory variables.

Variables: Acronyms and Definition

PVTDEBT This is ratio of the firm's total private debt to the
 firm's total debt outstanding. Book values are used.
 This serves as the dependent variable in Models 1 and
 2 below.

BANKDEBT This is ratio of the firm's total bank debt to the
 firm's total debt outstanding. Book values are used.
 This serves as the dependent variable in Models 3 and
 4 below.

PVTNON-BANK This is ratio of the firm's total non-bank private
 debt to the firm's total debt outstanding. Book values
 are used. This serves as the dependent variable in
 Models 5 and 6 below.

AGE Age is the number of years since the firm's
 incorporation, as of the year 2002.

FAR The fixed asset ratio (FAR) is calculated as the ratio
 of the firm's net fixed assets to total assets.

MB The market value-to-book ratio (MB) is the firm's the
 sum of the book value of liabilities plus market
 capitalization, divided by the book value of total
 assets.

SD This measure of stock volatility is the standard
 deviation of the firm's daily returns average over a
 365-day period.

LNASS This is the natural log of the firm's total assets,
 and is used as a proxy for firm size.

LEV Leverage (LEV) is calculated as the ratio of the book
 value of total liabilities over the book value of
 total assets.

BANKOWN This is the proportion of common stock of the firm
 owned by banks.

As the criteria for sample selection indicate, this study considers those firms that have public debt outstanding. The motivation for such a focus lies in the fact that India is still a "bank-oriented" economy (Aivazian et al., 2003, employ this particular term for India in their international comparisons of dividend policy). Indian firms have historically been dependent on state-owned banks and other private credit for their financing, and have had little access to a well-developed public debt market. For example, of the 900 or so manufacturing firms for which data is available, only about 70 firms are without bank debt in their capital structure, and almost all of these 70 firms have no public debt either. As suggested above, about 300 firms have public debt, which means roughly 600 firms, or 67% of the total, do not carry any public debt whatsoever. As suggested by several theoretical models, accessibility to public debt is likely limited to firms on the higher end of the credit quality spectrum. The question the present study addresses is whether these firms can benefit from the screening and monitoring role of private debt and, more specifically, bank debt, even though they have access to public debt. In other words, does "reputation" substitute perfectly for "monitoring"? As in Johnson, 1997a, 1997b, the present study uses the absence of public debt as a proxy for a lack of access to public debt.

Three continuous variables are used alternatively as dependent variables in OLS regressions. First, in Models 1 and 2 below, the proportion of the firm's private debt (PVTDEBT) is regressed on several variables suggested by earlier empirical studies of the debt placement choice. Those variables are discussed in greater detail below. Next, the firm's private debt is partitioned into bank debt (BANKDEBT) and non-bank private debt (PVT NON-BANK). The former is employed as a regressand in Models 3 and 4, while the latter is the regressand in Models 5 and 6. The purpose of this step is to determine, as in Johnson, 1997a, whether bank debt and other private debt differ in their relationship with firm-specific attributes such as leverage, information asymmetry, and growth opportunities.

The choice of the independent variables listed above is based on the fact that in several of the studies discussed in the literature review section, firm-specific factors such as age, size, leverage, growth opportunities, and information asymmetry appear systematically to affect the ownership structure of corporate debt. Johnson, 1997a, uses "age", or the number of years since incorporation, as a proxy for reputation to test the Diamond, 1991, hypothesis regarding the role of reputational capital and choice of public debt. Since the reputational capital of older firms ensures that they will avoid actions harmful to creditors even if unmonitored (given that their reputation is valuable and represents a large investment at risk if tarnished), it is expected that AGE will be negatively related to the use of private debt.

Numerous studies employ the natural logarithm of a firm's total assets (LNASS) as a proxy for information availability and/or economies of scale in flotation costs (as found in Easterwood & Kadapakkam, 1991). Some of the studies employing this proxy include Krishnaswami et al.,1999, and Hadlock & James, 2002. Since size is used as a positive measure of information availability and economies in floatation costs, it is expected that LNASS will be negatively related to the use of private debt.

Krishnaswami et al., 1999, employ the residual volatility in a firm's stock returns as a proxy for information asymmetry. Hadlock & James, 2002, argue that firms with greater stock return volatility are more likely to possess large information asymmetry between insiders and outsiders. The latter measure this volatility as the standard deviation of the firm's daily stock returns. Since private creditors are argued to possess an advantage in information production, it is expected that there will be a positive relationship between the volatility measure, SD, and the firm's dependence on privately placed debt.

Several studies use the market-to-book ratio (MB) as a proxy for the firm's growth options (e.g., Barclay & Smith, 1995; Krishnaswami et al., 1999; Hadlock & James, 2002). Most of these studies also recognize that growth options may be difficult to value, and MB could therefore proxy for asymmetric information as well. To the extent that MB is a measure of intangible assets, it could also be a proxy for potential asset substitution problems. Given the special role attributed to private lenders in theoretical models, it might then be expected that MB will be positively related to the use of private debt. However, if "hold up" problems of the kind suggested in Rajan, 1992, apply to private debt, then firms with higher growth options will tend to avoid such debt. MB would then be negatively related to private debt use. This negative relationship can also be predicted if MB is a proxy for low liquidation values (as in Johnson, 1997a, for example). A greater proportion of the value of high MB firms is derived from future cash flows rather than assets-in-place, and they are therefore likely to have lower liquidation value. As argued earlier, firms with projects of low liquidation value will attempt to avoid the harsher covenants of private debt. Given these arguments, there is no clear 'a priori' expectation with regard to the direction of relationship between MB and the use of private debt.

Johnson, 1997a, 1997b employs the ratio of fixed assets to total assets (FAR) as a proxy for the assets that can be used as collateral to reduce the asset substitution problem associated with debt. A mitigation of this problem implies a reduced need for ex-post monitoring, which in turn suggests that FAR should be negatively related to use of private debt. On the other hand, FAR can also be used as a proxy measure for project liquidation values, in which case FAR should be positively related to the use of private debt. As such, there is no clear 'a priori' expectation with regard to the direction of relationship between FAR and the use of private debt.

Theory suggests that firms with lower leverage would tend to have public debt, since the greater equity-at-risk for these firms tends to bond managers' investment behavior (Hoshi, Kashyap & Scharfstein, 1993). Therefore, it is expected that there will be a positive relationship between LEV and the use of private debt. It should, however, be noted here that including leverage directly in the equation as an explanatory variable is problematic, because capital structure studies have demonstrated it to be related to such factors as firm size, asset collateral value, and growth opportunities--factors that are also included here as explanatory variables. Along the lines of Johnson, 1997a, therefore, the present study uses, for LEV, the residuals from regressing leverage on the other explanatory variables, these residuals representing the "exogenous" part of leverage.

Finally, this study includes the proportion of the firm's equity owned by banks (BANKOWN) as an explanatory variable. This is motivated by the Rajan, 1992, "lock-in" model, which indicates that a firm's preference for bank debt (and bank debt maturity) is partly a function of its bargaining position vis-a-vis the lender. A suggested proxy for bargaining power is the bank's ownership of the firm's equity. Given data restrictions, this study takes the total proportion of equity owned by banks as an approximation of this bargaining power. Rajan's model suggests that the distortion of the owner/manager's incentives from short-term bank borrowing increases as his/her bargaining power decreases; in this case, the firm chooses "arms-length" debt or long-term bank debt in order to correct the incentives for effort. Among the sample firms, bank borrowing is predominantly short-term. Accordingly, a negative relationship between BANKOWN and private debt use and/or bank debt use would be consistent with the Rajan model. It should be reiterated, though, that the proxy measure employed here is a very crude measure of the bargaining power discussed in Rajan, 1992, and the results should therefore be interpreted with caution; this study includes the ownership variable merely as a first step towards empirically examining a hitherto untested proposition. The hypothesized relationships are summarized in Exhibit 1.

PATTERN OF PRIVATE DEBT USE: REGRESSION RESULTS

This section reports the cross-sectional regularities found in the use of private debt, bank debt, and non-bank private debt among the sample firms. While three sets of models are therefore estimated, each set includes two regressions--one with the BANKOWN variable, the other without--for a total of six models. Models 1 & 2, shown in Table 1 below, pertain to the use of private debt. The relationships for the two components of private debt, namely, "bank" and "non-bank" private financing, are seen in Models 3 through Model 6, reported in Table 2.

As can be seen in Table 1, four of the six variables in the private debt equation (Model 1) are significant, and possess the hypothesized directions of relationship with private debt use. Firms with greater information asymmetry (as reflected in smaller asset size, LNASS, and larger volatility of stock returns, SD) appear to depend more on private debt. More levered firms (those with higher values of LEV) depend more on private debt (and therefore less on public debt), which is consistent with the notion that in high leverage firms, the lower equity-at-risk distorts investment incentives, and such firms will require monitoring. The negative coefficient for MB is consistent with the idea that firms with more valuable growth opportunities (or those with lower liquidation values), try to stave off bank hold-up problems (or avoid inefficient liquidation). Neither AGE nor FAR is significantly related to the degree of private debt use among the sample firms. Model 2, which differs only in its inclusion of BANKOWN, shows qualitatively similar results. In addition, the estimated equation indicates that there is no significant relationship between a firm's dependence on private debt and the proportion of its equity that is owned by banks.

Table 2 reveals clear differences in the pattern of bank and non-bank private debt use. No factor has a common influence on the two types of debt. AGE, FAR, and BANKOWN appear now as significant factors (albeit AGE marginally so in Model 5), but with opposite signs in the two sets of equations. LNASS and MB are significant in the "bank" equation, but not in the "non-bank" equation. SD and LEV are significant in the "non-bank" equation, but not in the "bank" equation.

It might have been argued that the positive (negative) sign for AGE in the bank (non-bank) equation is consistent with the "reputation building" process in Diamond, 1991, were it not for the fact that the sample firms have access to public debt, suggesting that they already possess "reputational capital". Thus, the estimated relationship for AGE is puzzling.

One measure of information asymmetry (LNASS) plays a significant role in the "bank" equation, while the other measure (SD) possesses explanatory power in the "non-bank" equation. If larger firms have economies in public debt issuance, then flotation cost considerations, rather than information asymmetry, may explain the negative effect of LNASS in the "private" and "bank" equations. Taken in this light, the positive influence of AGE and the insignificant coefficient for SD in the "bank" equation hint at a rule-bound banking system that plays no appreciable role in the mitigation of the adverse selection problem. The continuation of government-mandated "directed credit" policies could explain this observed relationship.

The "hold-up" problems associated with bank information monopolies in Rajan, 1992, are linked both to bank debt maturity and to the number of lending banks, factors not explicitly accounted for in the present study. Therefore, the significantly negative coefficient for MB in the "bank" equation is more safely interpreted as reflecting the strategy by firms with high MB ratios to avoid inefficient liquidation. An implication of this argument is that bank debt covenants, rather than simply "private debt" covenants, tend to be harsh and more likely to force early liquidation.

The negative effect of FAR in the "bank" equation suggests that firms with potentially greater asset substitution problems (i.e. those with a smaller FAR) will lean more heavily on bank financing. According to this interpretation, banks play a useful ex-post monitoring role. However, LEV is not significant in the "bank" equation, whereas it is significantly positive in the "non-bank" model. The latter result indicates that firms with less collateral-at-risk, who had been seen in Models 1 and 2 to depend on private debt, specifically rely on "non-bank" private debt.

This points to a monitoring role for non-bank private debt as well. Finally, a greater control by lending banks, as approximated by larger values for BANKOWN, seems to induce firms to lean more towards non-bank private debt, and less towards bank financing. There is, therefore, at least prima facie evidence that the ownership structure of equity--especially with respect to banks' claims--has a bearing on the ownership structure of corporate debt. Since bank debt in the sample is predominantly short-term, the reported results are consistent with Rajan, 1992, though more detailed research is required before a definitive statement can be made in this regard.

CONCLUSIONS AND IMPLICATIONS

One of the contributions of the present study is that it documents the existence of cross-sectional regularities in the degree of private versus public debt use in an emerging economy. Information asymmetry, asset substitution problems, concerns of inefficient liquidation, and bonding of managerial investment behavior, appear to affect the private/public debt mix in the firm's debt structure. Specifically, firms with greater information asymmetry, larger liquidation values, smaller fixed assets ratios, and higher leverage make greater use of private debt. A separate analysis of bank debt use suggests that Indian banks play a greater role in combating moral hazard via ex-post monitoring and control than in mitigating the adverse selection problem via information production ex-ante. Proxies for potential asset substitution problems tend to be significant in the "bank debt" equation, but proxies for information asymmetry appear significant in the "non-bank debt" equation. As mentioned earlier, state intervention, such as mandatory directed credit policies, could account for the unexpected results relating to the proxies for information asymmetry.

The fact that the estimated models reveal meaningful and significant patterns in corporate debt does indicate that the Indian firm attempts--and the institutions in India at least partially allow--a process of economic optimization anticipated by mainstream finance theory. Nevertheless, the findings reported above point to the need for a continued reform of the Indian banking sector. Also, this paper makes a first attempt at empirically examining hitherto untested propositions of the link between bank control and corporate preferences for bank financing. It documents a significantly negative effect of bank ownership on a firm's dependence on bank debt. The study also demonstrates that vastly different relationships can exist between firm characteristics and the use of "bank" debt on the one hand, and "non-bank" private debt on the other. Existing models do not predict all the differences in the relationships for bank and non-bank private debt observed in this and previous studies (such as in Johnson, 1997a). It would be fruitful for future empirical, and, more importantly, theoretical research on the structure of corporate borrowing to distinguish between the different sources of private debt. Subject to the availability of data, future research should also partition bank debt into its short-term and long-term components in an attempt to test existing hypotheses with regard to the maturity preference of bank debt.

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Sanjay Rajagopal, Montreat College

Table 1: Regression Models for Private Debt

Variable Model 1 Model 2

Intercept 0.9640 *** 0.9200 ***
Age 0.0003 0.0003
LNASS -0.0204 ** -0.0195 **
SD 0.0132 *** 0.0183 ***
Mkt/Bk -0.1851 *** -0.1796 ***
FAR 0.0554 0.0697
LEV 0.4164 *** 0.3863 ***
Bankown -- 0.0001
N 303 266
F 18.34 *** 15.27 ***
Adj. R-Sq. 0.26 0.27

Each cell shows the estimated coefficient.

LEV is the residual from the regression of leverage on the other
explanatory variables.

*** significant at the .01 level

** significant at the 0.05 level

* significant at the 0.10 level.

Table 2: Regression Models for Bank Debt (Models 3 & 4) and Non-Bank
Private Debt (Models 5 & 6)

Variable Model 3 Model 4 Model 5 Model 6

Intercept 0.7917 *** 0.7274 *** 0.1722 ** 0.1927 **
Age 0.0012 ** 0.0014 ** -0.0009 -0.0011 **
LNASS -0.0220 ** -0.0152 0.0016 -0.0044
SD 0.0011 0.006 0.0121 ** 0.0123 **
Mkt/Bk -0.1784 *** -0.1760 *** -0.0067 -0.0036
FAR -0.3098 *** -0.2656 *** 0.3652 *** 0.3353 ***
LEV -0.0285 -0.0697 0.4449 *** 0.4559 ***
Bankown -- -0.0030 ** -- 0.0032 **
N 303 266 303 266
F 10.37 *** 8.72 *** 15.20 *** 12.05 ***
Adj. R-Sq. 0.16 0.17 0.22 0.23

Each cell shows the estimated coefficient.

LEV is the residual from the regression of leverage on the other
explanatory variables.

*** significant at the .01 level

** significant at the 0.05 level

* significant at the 0.10 level.

Exhibit 1
Variables: Hypothesized Direction of Relationship with Private Debt

Variable Hypothesized Influence on Proportion of Private Debt

AGE Negative
LNASS Negative
SD Positive
MB ?
FAR ?
LEV Positive
BANKOWN Negative