The link between corporate debt market make-up and company financing decisions
Nowadays, most debt originates from banks, but is then distributed to institutional investors. Many such investors require the ability to trade in secondary markets. As a result, the rise in debt financing was accompanied by a substantial expansion in secondary market activity for debt instruments. The EU-funded CORPDEBTMKT (The structure of corporate debt markets and firm financing decisions) project extensively investigated this interplay. Project partners studied how the need of investors to trade in secondary markets ultimately shapes the debt instruments with which firms finance themselves. They also documented the changing role of banks in debt origination, and how this changing role leads to new risks for banks. Key findings were published in two major papers. The first shows how a lack of liquidity in the secondary market can bring corporations to choose maturities that are inefficiently short. The second paper discusses how demand discovery is the main function of banks that arrange syndicated loans. Specifically, banks need to find out how much institutional investors are willing to pay in order to place the loan on the best possible terms for the borrower. Demand discovery implies that banks sometimes have to retain more of the debt than they intended to when investors indicate a low willingness to pay. Empirical results suggest that when such retention occurs, the affected banks subsequently reduce their arranging and lending activities by statistically and economically significant amounts. As a consequence, this retention can have adverse effects on the supply of credit. CORPDEBTMKT outcomes will have important implications for a couple of domains. One is for the regulation of maturity choice, such as that taking place under the net stable funding ratio which has been proposed within Basel III, the new set of capital requirements for banks. The other is for syndicated lending regulation, for example the relevant guidance already in place in the United States and the guidance currently being considered by the European Central Bank.