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Investment in R&D creates intangible, firm-specific assets that can facilitate and drive firm competitive advantage
(Branch, 1974, Chauvin and Hirshey, 1993). Yet, relationships with providers of capital to fund R&D investment are
rife with transaction costs, which include ex post adaptation and enforcement costs due to uncertain revenue
streams, low R&D collateral value, and information asymmetries and monitoring difficulties. Transaction costs
theory prescribes the discriminating alignment of governance structures with transaction characteristics
(Williamson, 1985). Though equity as a governance structure is typically considered more efficient than debt to
govern asset-specific investments such as R&D (O’Brien, 2003; Vicente-Lorente, 2001, Williamson, 1988), debt is
heterogeneous. Bank loans have been characterized as having firm-like (i.e., hierarchical) attributes and bonds have
been characterized having market-like attributes (David, O’Brien, and Yoshikawa, 2008). The firm-like attributes of
bank loan debt include adaptation through forbearance and enforcement through monitoring of managerial activity.
Using transaction cost theory, we argue that although equity is best perceived as firm-like (i.e., hierarchical) and
bonds are best perceived as market-like, bank loans can be viewed as hybrid-like. Equity, as a firm- or hierarchicallike governance mode, provides weaker incentives yet offers more adaptability and monitoring of managerial
decision-making. Bonds provide high powered incentives for firm performance since (potential bankruptcy) yet do
not provide on-going monitoring and adaptability to unforeseen circumstances. Bank loans, however, share some
firm-like characteristics such as managerial monitoring and adaptation and some market-like incentive mechanisms.
However evidence of the monitoring role of banks is mixed (David et al, 2008; An & Choi, 2009; Morck &
Nakamura, 1999, Weinstein and Yafeh, 1998, Diamond 1991; Kang & Shivdasani, 1997).
We argue that the extent to which bank loans act more firm-like or market-like stems from whether banks hold
ownership positions in borrowing firms. Bank loan debt can facilitate adaptation through flexibility (forbearance) of
initial loan agreements and enforcement benefits through more effective monitoring. However, the addition of
equity stakes provides additional incentives to monitor risky investments such as R&D. In the absence of ownership,
increased organizational costs of bank debt relative to bonds without the benefits of increased monitoring and
adaptability make bank loans less efficient to govern R&D investment than bonds.
We test this theoretical framework using a sample of Japanese firms from 1998-2007. We find that when banks
hold substantial equity in the borrowing firm, there is a positive interaction between bank loan debt and R&D
intensity on firm performance. In contrast, when banks do not hold substantial ownership positions in firms, there is
a negative interaction between bank loan debt and R&D intensity on firm performance. Our results suggest that
David et al.’s (2008) finding that bank debt relative to bond debt governance for R&D investment has performance
enhancing effects may be influenced by the significant equity holdings of banks during their sample period. Our
results suggest that it is only when banks hold borrowing firm ownership positions that bank loan debt exhibits firmlike characteristics, which include increased monitoring and adaptability.
Strategy research on the governance of R&D often focuses on either equity characteristics (e.g., Graves, 1988; Kor,
2006; Lee and O’Neill, 2003) or capital structure (e.g., O’Brien, 2003; Long and Ravenscraft, 1993) or debt
characteristics (e.g., David et al., 2008). Our paper provides one theoretical linkage between these two streams of
research, that of bank ownership. Viewing bank loan debt as a hybrid governance mode sets the stage for new
theoretical insights, some of which we develop and test in this paper and others about which we only conjecture. It
also considers an important dimension of the institutional environment found in many countries, reliance on both
bank ownership and bank lending.
R&D activities are difficult to monitor, and the eventual success of R&D investments and the revenue stream
generated are uncertain. R&D investment creates intangible, knowledge-based and firm-specific assets (Hillier et al.,
2011), which are more valuable in complementarity with existing firm assets than alone. Thus, the collateral value
of R&D-based assets is uncertain. While failure to meet covenants and other contractual obligations may trigger
action by creditors, they provide little on-going monitoring or control. Equity financing provides on-going
monitoring through the board of directors and incentives for managers to work to shareholder benefit. It therefore
provides adaptive capabilities to unforeseen circumstances. Agency theory also suggests a positive association
between equity and R&D due to the risk, uncertain outcomes and time horizons, and asset specificity of R&D
investments (e.g., Graves, 1988; Hill and Snell, 1988). Shareholder involvement in corporate governance permits
monitoring of risky investments such as R&D. An agency perspective on financial governance also considers the
adverse incentive effects that may hinder investment in potentially lucrative payoffs from R&D investments., for
example incentives to fund high risk investments such as R&D whose benefits accrue primarily to shareholders. The
potential for such ‘risk shifting’ (Myers, 1977; Smith and Warner, 1979) provides a further disincentive for
extending credit to risky firms.
Numerous empirical studies show a positive relationship between R&D and equity financing (e.g., Balakrishnan and
Fox, 1993; Long and Ravenscraft, 1993; Titman and Wessels, 1988; Vicente-Lorente, 2001). The uncertainty of the
degree and frequency of revenue generation associated with R&D investment increase the risk of R&D strategies
and make it difficult for firms to service debt-induced scheduled principal and interest payments. Debt in the
aggregate works primarily through ex-ante protections such as covenants, requirements for regular interest
payments, and actions such as forced bankruptcy (Kochhar, 1996). Yet, debt is heterogeneous.
Effective governance of bank loan debt for R&D investment depends on bank ownership
There are two primary types of debt. Bonds are transactional in nature, and exhibit market-like characteristics.
Bonds are of fixed term and often traded on the open market. Bond holders are protected by debt covenants and
legal recourse, but have little ability for on-going monitoring. Given that there is no expectation of future
transactions, creditors have more limited incentives for mutual forbearance and adaptation through debt
renegotiation (David et al., 2008; Kochhar and David, 1996; Williamson, 1988). Bond holders do not provide a
monitoring function (Diamond, 1991). At the same time, bonds have low organizational costs.
The lack of flexibility for renegotiation, forbearance, and overall adaptation as a principal transaction cost concern
means that bonds, relative to bank loans, may not be well-suited to govern R&D investment, where returns can be
sporadic. Further, the enforcement mechanism for bond contracts is strict compliance with the terms of the bond
contract, where failure by firms to meet principal and interest payment schedules can lead to costly court
adjudication or bankruptcy. Thus, the financial contract of a bond is market-like whereby enforcement is costly and
adaptation is lacking. At the same time, there are low administrative or organizational costs since negotiation ex post
and ongoing management of the contractual relation is virtually absent. Finally, appropriation concerns, whereby a
firm divulges proprietary knowledge regarding its R&D activities, are not a concern.
Bank loans are private contracts between firm borrowers and lending institutions where the pricing and originating
of loans confer proprietary information to lenders. Given that bank loans may involve on-going banking
relationships, bank loan transactions can reduce information asymmetry between borrowers and lenders and provide
a greater incentive and ability for banks to monitor firm-level activity (Boot, 2000; Datta, Iskandar-Datta, and Patel,
1999; Hadlock and James, 2002). Banks also have greater flexibility regarding contractual terms of debt obligations
such as renegotiation if repayment becomes problematic or unlikely (Altman, Grande, and Sauders, 2010).
These advantages may incur additional costs. For example, maintenance of banking relationships requires ongoing
organizational costs. Banking relationships are characterized by strong ties, which means extensive communication
between borrowers and banking lender and often input into decision making. These strong ties increase the ability to
work things out, yet they come with organizational costs. Indeed, cost has been viewed as a major reason for the
increase in bond financing (and decline in bank financing) in Japan (Arikawa & Miyajima, 2005; Weinstein and
Yafeh, 1998; Miyajima, 2007). Further, bank involvement in firm decision making may constrain the firm’s
strategic options (Weinstein & Yafeh, 1998). Further, several authors have questioned the bank’s incentive to
monitor, particularly in Japan due to multiple business ties between banks and client firms (Weinstein & Yafeh,
1998), and managerial entrenchment and lack of transparency regarding the bank loan portfolio (Hanazaki, 2003;
Fok, Chang, & Lee, 2004; Hiraki, Ito & Kuroki, 2004).
When banks hold nontrivial ownership positions in firms, bank loan contracts are embedded in a relationship that
provides for adaptation and enforcement, the two principal transaction cost concerns from a TCE perspective. Equity
ownership provides additional monitoring incentives. Since equity positions allow banks to benefit from successful
R&D as residual claimants, they have greater incentives to promote promising R&D projects. These incentives,
combined with the flexibility inherent in bank lending (as compared to bonds) may encourage effective bank
monitoring. The reinforcing role of equity and debt is supported by Miyajima (2007) found that Japanese banks
tended to retain ownership in firms in which they had lending relationships, particularly long-term relationships.
Prior research on the relationship between bank loans and R&D investment has not considered the role of bank
ownership. We propose that the most efficient financial governance is a trade-off between the incentives for and
benefits of adaptation and enforcement vs. the costs of organization. The greater access to information and
multiplex ties between banks and firms available from banking relationships, reinforced with the ownership
incentives to monitor risky investments as residual claimants, encourage effective R&D investment. Thus, when
banks hold substantial ownership positions in firms, bank loan contracts appear to be a more appropriate mode of
financial governance than bond contracts, which leads to the following hypothesis:
Hypothesis 1. When banks hold substantial ownership positions in firms, there is a positive interaction between bank
loan debt and R&D intensity on firm performance.
Without ownership, weaker ties exist between banks and borrowing firms. These weaker ties do not facilitate
information asymmetry reduction and monitoring of managerial decision-making, which are important to govern
R&D investment. Without bank ownership, the enforcement mechanisms appropriate for R&D activity are also
lacking, relative to when banks own firms. Unless banks are equity holders of borrowing firms, banks have less of a
monitoring role and thus measurement and evaluation of borrowing employee inputs (R&D scientists and engineers)
is tempered.
The organizational costs of establishing and maintaining banking relationships may even be higher when banks do
not hold substantial ownership stakes in borrowing firms. Further, the ability of borrowing firms to keep knowledge
generated from R&D investment proprietary is likely more difficult when banks are not also owners. Thus, the
combination of lower benefits of adaptation and enforcement combined with greater organizational costs of banking
relationships when banks do not hold ownership stakes suggest that bank loans are less efficient to govern R&D
investment for firms that do not have banks as substantial owners.
Hypothesis 2. When banks do not hold substantial ownership positions in firms, there is a negative interaction
between bank loan debt and R&D intensity on firm performance.
Our preliminary methodology provides results consistent with our hypotheses. We empirically examine the firm
performance effects of bank loan debt and R&D investment under conditions when firms are substantially owned by
banks and when they are not. Our primary data source is the Bureau Van Dijk Osiris database, which provides
balance sheet and income statement financials for our sample of Japanese firms. We eliminated all finance,
insurance, real estate, and public administration firms. Industry dummy variables in the provided estimation results
were based on three-digit SIC industry classification codes. Since market value was used for some measures, our
sample includes only firms with public equity. Firms were deleted where just one year of data was available, since
we used lagged variables in our estimations. Several year-specific macroeconomic variables were provided by The
World Bank’s World Development Indicators (WDI, 2009). Our sample frame was 2001-2008. Our year dummy
variables allow us to control for changes in regulatory context which may have occurred within our sample countries
(Anderson and Makhija, 1999; Arikawa and Miyajima, 2005; Johnson, 1997). Our unbalanced, panel data sample
represents 3874 firm-year observations.
The dependent variable, Firm performance, was measured as the market value of equity divided by the sum of the
book value of debt and the book value of equity, which is consistent with previous research (David et al., 2008). In
our analysis, we estimate Firm performance at year t, while we include lagged independent variables (year t – 1).
The explanatory independent variable, R&D intensity was measured as total research and development expenses
divided by revenues. The explanatory independent variable, Bank loans, was calculated as bank debt divided by total
debt. We measure substantial bank ownership as a binary variable, which equals 1 if a firm’s first or second major
shareholder is a bank and equals 0 otherwise. We use this binary variable to split our sample into firms with and
without substantial bank ownership. Our models also include several variables that have been shown to be linked to
firm performance, R&D investment, and debt use in previous research. To control for the effects of firm reliance on
debt or equity on R&D investment, all estimations include the variable Equity financing (or leverage), measured as
total debt divided by total debt and the market value of equity. Our models include the variable Firm size, measured
as total revenues. We also include the control Interest coverage, measured as income from operations minus
depreciation and divided by interest and discount charges, as a measure of firm financial flexibility or slack
resources. ROA (return on assets), was also included and measured as operating income divided by total assets. We
also include several country-level variables that vary by year. Domestic credit, is measured as the amount of
domestic credit provided to the private sector by domestic banking institutions as a percentage of gross domestic
product (GDP) in current US$. To control for access to market capital, we controlled for market capitalization of all
firms in a particular country as a percentage of GDP (Market cap/GDP). We controlled for GDP per capita,
measured as GDP per capita in current US$ as well as GDP growth, measured as the annual percentage growth of
GDP. Finally, our estimations include year and industry fixed effects.
Table 1 reports preliminary results of several regression estimations. This preliminary analysis uses robust
regression, which uses weighting techniques to address outlier observations. Model 1 is a control model using the
full sample where the coefficient is that of R&D intensity X Equity, which is positive, consistent with existing
research that equity is an effective governance mechanism for R&D investment. Models 2 and 3 are also control
models for subsamples that include firms with (Model 2) and without (Model 3) bank ownership. In Model 4,
which is the subsample of firms with bank ownership, the estimated coefficient of R&D intensity X Bank loan debt
is positive and statistically significant, consistent with Hypothesis 1. In Model 5, which is the subsample of firms
without bank ownership, the estimated coefficient is negative and statistically significant, supporting Hypothesis 2.
Thus, bank loan debt acts more firm-like when firms are owned substantially by banks and bank loan debt acts more
market-like when firms are not substantially owned by banks. The hybrid nature of bank loan debt is variable,
depending on bank ownership, and this variation directly affects whether bank loans are good to govern R&D
investment (i.e., whether bank loan debt is performance enhancing). Our preliminary results suggest that the
monitoring, enforcement, and adaptation mechanisms of bank loan debt are worth the added organizational costs of
banking relationships when banks substantially own firms. However, when banks do not have substantial ownership
positions in firms, the added organizational costs of banking relationships mean that bank loan debt is actually worse
(i.e., performance decreasing) than bond debt to govern R&D investment.
We will further develop our preliminary analysis in several ways. For a more robust test of our existing set of
hypotheses, collection of additional bank ownership data will allow us to use dynamic panel data estimation
techniques to control for potential endogeneity concerns. For subsequent and additional hypotheses development, we
will also consider other ownership-related factors that may be important to understanding the linkage between equity
and debt characteristics on effective R&D governance. We will also examine the role of additional categories of
owners (e.g., foreign investors) which may mitigate the reinforcing role of bank ownership. Also, there may be
counter-veiling forces with respect to effective R&D governance related to the identity of blockholders and to the
dispersion of ownership more generally. For example, Hoskisson et al. (2002) found that different types of
institutional owners affected the extent of internal innovation, and Lee and O’Neill (2003) examined the relationship
between ownership concentration and R&D investment. These additional and related theoretical considerations
should enhance the value-added of our paper.
Table 1. Robust regression results for Firm performance a
Full Sample
With Bank
No Bank
With Bank
No Bank
Firm performance (lagged)
R&D intensity
Bank loan debt 0.014
Equity Financing
Firm size
Interest coverage
R&D Intensity X
Equity Financing
R&D intensity X
Bank loan debt
Domestic credit
Year fixed effects
Industry fixed effects
Market cap/GDP
GDP per capita
GDP growth
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
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