The recent sub-prime crisis has put financial risk, and its effects on participating actors, in a central position for the proper functioning of capital markets. We examine the management of such financial risks from the perspective of two interested actors: financial institutions that act as lenders, and industrial firms that act as borrowers. This paper examines financial interlocks between banks and industrial companies, and its relationship to earnings quality and the cost of debt. This issue is especially pertinent given the inherent conflict of interest present between banks and industrial firms, and their poorly understood inter relationships.
In this paper, we document that the incidence of financial executives on the board of industrial firms (hereafter “bankers”) is negatively related to earnings management by the relevant industrial firm, suggesting a monitoring/control role that constrains opportunistic behaviour on behalf of management. On the other hand, the incidence of industrial executives on the boards of banks (hereafter “industrials”) is positively related to earnings management by the industrial firm. This suggests that industrial firm executives who hold a board position in a bank, effectively capture the monitoring function of banks. Additional analysis reveals that bankers also play an opportunistic role as well, protecting their investments when earnings of the industrial firm falls.
Prior studies on financial interlocks have examined the role of bankers, suggesting that firms may gain several benefits by having bankers on their boards, including debt market expertise, financial or investment advice (Byrd, Mizruchi, 2005). Additionally, bankers may play a certification role, helping a firm secure capital from other banks, public debt markets, or from investors (Fama, 1985; Kracaw and Zenner, 1998; Booth and Deli, 1999; Ferreira and Matos, 2007). From the perspective of the bank, board representation enables the monitoring of top management, and leads to a better assessment of credit worthiness (Kroszner and Strahan, 2001). However, having bankers on the board leads to conflicts of interest due to their fiduciary duties towards both the shareholders of the industrial firm, and toward their respective bank, hence, resulting to an inherent conflict between debtholders and shareholders.
Given this conflicted role, bankers have the incentive to behave opportunistically leading to an information-based monopoly (Rajan, 1992; Kracaw and Zenner, 1998). Given the greater access to information and the pricing advantage of interlocked banks, non interlocked banks may shy away from lending to the firm (Rajan, 1992), in effect, allowing interlocked banks to extract rents (Rajan, 1992; Kracaw and Zenner, 1998). Therefore, the role of bankers on the boards of industrial firms is a controversial one, and prior research has not clearly established the role of bankers and their motivations.
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Financial Interlocks and Earnings Management: Evidence from Italy
