Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring Who Monitors the Monitor? Bank Capital Structure and Borrower Monitoring

Abstract The role that banks play in screening and monitoring their borrowers is well understood. However, these bank activities are costly and unobservable, thus difficult to contract upon. This introduces the possibility of shirking and leads to the question -who monitors the monitor? Financial intermediation theories posit that bank capital structure plays such a role in incentivizing banks to monitor their borrowers. Both bank debt and bank equity have been proposed in various theories as providing the discipline to induce banks to monitor. However, empirical evidence on how bank capital structure influences borrower monitoring is scant. To circumvent identification concerns with regressing (unobservable) bank monitoring on (endogenous) bank capital structure, we use variation in country-level creditor rights to capture banks' need to monitor their borrowers. We develop a theoretical model in which greater ex-post protection offered to lenders (i.e., banks) during borrower bankruptcy/renegotiation reduces the bank's ex-ante incentives to monitor. This is because the greater salvage value of bank loans reduces the bank's expected loss from not monitoring. Our model also examines how banks alter their capital structures in response to changes in their country's creditor rights, and shows that the reduced demand for bank monitoring induced by stronger creditor rights induces the bank to shift its capital structure away from the source of financing that induces it to monitor. We find empirically that increases in creditor rights result in banks tilting their capital structures away from equity and towards deposits. We verify (theoretically and empirically) that these demandbased tilts in bank capital structure are not explained by supply-side effects (i.e., creditor rights make it cheaper to supply bank debt), and conclude that bank equity is a stronger source of discipline on banks than bank debt. JEL classification: G15, G21, G3