Bank Monitoring and Investment - National Bureau of Economic

This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Asymmetric Information, Corporate Finance, and Investment Volume Author/Editor: R. Glenn Hubbard, editor Volume Publisher: University of Chicago Press, 1990 Volume ISBN: 0-226-35585-3 Volume URL: http://www.nber.org/books/glen90-1 Conference Date: May 5, 1989 Publication Date: January 1990 Chapter Title: Bank Monitoring and Investment: Evidence from the Changing Structure of Japanese Corporate Banking Relationships Chapter Author: Takeo Hoshi, Anil Kashyap, David Scharfstein Chapter URL: http://www.nber.org/chapters/c11469 Chapter pages in book: (p. 105 - 126) Bank Monitoring and Investment: Evidence from the Changing Structure of Japanese Corporate Banking Relationships Takeo Hoshi, Anil Kashyap, and David Scharfstein 4.1 Introduction Economists typically view banks as intermediaries that serve to channel

funds from individual investors to firms with productive investment opportu- nities. This commonly held view, however, is difficult to reconcile with the assumption of frictionless capital markets: in frictionless markets, firms would raise capital directly from individual investors and avoid the costs of intermediation.1 This paper offers empirical evidence on the benefits of intermediation. Our explanation for the existence of financial intermediaries derives from the view that there may be important capital-market frictions created by information problems between firms and investors. We view banks and other financial intermediaries as institutions designed in part to circumvent these capital- market imperfections. Specifically, banks serve as corporate monitors who pay the costs of becoming informed about their client firms and who try to ensure that the managers of these firms take efficient actions. This view of the role of banks is not new. Schumpeter (1939) argued infor- mally along these lines, and Diamond (1984) has constructed a formal model Takeo Hoshi is assistant professor of economics at the Graduate School of International Rela- tions and Pacific Studies, University of California, San Diego. Anil Kashyap is an economist in the Division of Research and Statistics at the Board of Governors of the Federal Reserve System. David Scharfstein is associate professor of finance at the Massachusetts Institute of Technology, Sloan School of Management. The authors thank Glenn Hubbard for useful conversations on numerous occasions. They are also grateful to Yasushi Hamao, Takatoshi Ito, Jim Kahn, John McMillan, Jim Poterba, and con- ference participants for helpful comments and to Masako Niwa, William Kan, and Andrew Wied- lin for valuable research assistance. The data were generously provided by the Nikkei Data Bank Bureau. The views expressed in this paper are those of the authors and do not necessarily reflect the opinions of the Board of Governors of the Federal Reserve or its staff. 105 106 T. Hoshi/A. Kashyap/D. Scharfstein that captures these and related ideas. Diamond shows that delegating the task of monitoring to a financial intermediary minimizes monitoring costs. The alternative—issuing securities like public debt and equity—may be inefficient either because monitoring costs are needlessly duplicated among individual security holders or because monitoring is a public good that no one has an incentive to provide. Of course, this raises a potentially troubling question: Who ensures that banks monitor the firms in which they invest? Diamond shows that bank diversification plays a key role in ensuring that...

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