External Governance and Debt Structure

This paper examines how external governance pressure provided by both the product market and the market for corporate control affects the type of debt that firms issue. Consistent with a governance substitution effect, we find that (i) an exogenous increase in governance pressure from the product market has a significant negative impact on the use of bank financing over public debt issuance, and (ii) an exogenous decrease in governance pressure from the takeover market has a significant positive impact on the use of bank financing. Tests using changes in the strictness of loan covenants provides corroborative evidence. Also consistent with bank specialness in providing governance, we find that a bank loan issue causally increases total factor productivity of firms by 1% to 1.6% per year over a bond issue for up to four years after the issuance. We interpret these findings as consistent with the notion that firms endogenously substitute among alternative governance mechanisms in devising a governance structure that allows external capital to be raised at the lowest possible cost and that demand for creditor governance depends on the relative strength of alternative external governance mechanisms