RDP 9311: Agency Costs, Balance Sheets and the Business Cycle 1. Introduction

Over-indebtedness means simply that debts are out-of-line, too big relatively to other economic factors. If the debts are out-of-line relatively to only a few unimportant factors, little harm may result. The great disturbances come when the debts are decidedly out-of-line with practically everything – including assets, income, gold and liquidities … Irving Fisher (1933, p.11)

The importance of balance sheets in the evolution of the macro-economy has generated significant interest over recent years. This increased interest follows a rise in both corporate leverage and real asset prices in a range of countries in the 1980s. More recently, real asset prices have fallen, and many corporations have attempted to reduce leverage. These developments have sparked concern that changes in financial structure have amplified the current business cycle. In this paper we review the mechanisms through which such an amplification might occur. In addition, we review the Australian experience with particular regard to the implications of asset price inflation for the conditions under which finance is made available.

Changes in the structure of the balance sheets of corporations and financial institutions can alter the response of the economy to aggregate demand and asset price shocks. The link between balance sheets and the business cycle has its roots in asymmetries in information between borrowers and lenders, and between owners and managers. The asymmetries lead to distortions in decision making, and these distortions impose certain costs. The size of these ‘agency costs’ is, in general, a decreasing function of corporate collateral or equity. As a result, the distortions and costs in an economy in which firms are initially highly geared are likely to be larger than in an equivalent economy with lower debt. These larger distortions can lead to a longer and more amplified business cycle in the high debt economy.

To date, models that emphasise a link between financial structure and economic activity have focused on the relationship between corporate equity and the supply of intermediated credit. While the models differ in their structure, the key mechanism is often the same. Specifically, an increase in leverage increases the probability that the firm will be unable to meet its contractual obligations. From the point of view of the provider of finance, this increase in the probability of default adversely effects the incentives of the firm. As a result, the interest rate charged by an intermediary is an increasing function of the leverage of the firm. In the limit, the intermediary may be completely unwilling to extend credit at any price. Higher interest rates, and equilibrium credit rationing, result in fewer investment projects being undertaken.

The models that emphasise this type of mechanism generate a link between financial structure and the evolution of the business cycle through the conditions under which external finance is supplied. Deterioration in firms' equity, through an adverse demand shock, or a fall in asset prices, will cause the loan supply curve to shift to the left. The shift can be compounded if the adverse shock causes loan defaults which reduce the capital of financial intermediaries. With lower capital, financial institutions may decide to reallocate their portfolios away from business loans towards safer assets. Only after a period of balance sheet reconstruction by financial institutions and corporations, will the loan supply curve return to more normal levels.

While there has been considerable theoretical work on the relationship between financial structure and the supply of finance, there has been considerably less work on the relationship between financial structure and the demand for finance. This is surprising given that to a large extent, recent balance sheet reconstruction reflects the desire of management to reduce leverage, not so that they can obtain funds from financial intermediaries on more favourable terms, but to reduce the probability of corporate failure. In general, managers are unable to diversify away the risk associated with losing their current job and their firm-specific capital. Thus high leverage can reduce the incentives of risk-averse management to undertake risky investment.^[1] As a result, high leverage can lead to a reduction in the demand for funds from financial intermediaries. Consequently, the link between corporate financial structure and the evolution of the business cycle operates not only through the conditions under which funds are supplied, but also through the demand for funds. The combination of a reduced supply of funds at any given interest rate, and a reduced demand for funds at any given interest rate, may lead to a prolonged period of slow output growth.

In this paper, as well as reviewing some of the recent models that link credit supply to the financial structure of firms and financial intermediaries, we develop a model which focuses on demand side factors. The model relies on management incentives that differ from those of the firm's owners. Since managers are not able to hold diversified portfolios of jobs, they dislike corporate collapse more than do the owners of the firm. As a consequence, investment decisions by management are a function of the financial structure of the firm. Once equity falls below a critical level, managers may not be prepared to undertake risky, but positive net value investment, but instead may attempt to recapitalise the firm through retention of earnings.

Ideally, it would be desirable to test the implications of the various models presented in the paper. While some recent advances have been made in this regard, in general the tests have tended to focus on the micro implications of the agency cost literature. This work is briefly reviewed in the paper.

Unfortunately, to date there has been relatively little empirical work directly linking agency costs and financial structure to the evolution of the business cycle. We examine this issue using Australian evidence. In particular, we focus on the cost of external finance and the conditions under which it has been extended. Our results suggest that, controlling for expected changes in business conditions, asset price inflation leads to a rightward shift of the loan supply curve. Increases in asset prices, by increasing the perceived collateral of firms, make financial institutions willing to supply a greater volume of funds at any given interest rate. This is consistent with the agency cost models. It also suggests that a fall in asset prices will see tighter credit conditions.

The remainder of the paper is structured as follows. In Section 2, we review the various mechanisms through which financial structure may impact on the evolution of the business cycle. In Section 3, we model the interactions of management incentives, financial structure and investment. We review the empirical work on agency costs and discuss the Australian experience in Section 4. Finally, in Section 5, we summarise and conclude.

Footnote

This is in contrast to the standard Modigliani-Miller (1958) proposition that the firm's investment decisions are independent of its financial structure. [1]