Banks have a significant funding-cost advantage if their liabilities are protected by bailout guarantees. We construct a corporate finance-style model showing that banks can exploit this funding-cost advantage by just intermediating funds between investors and ultimate borrowers, thereby earning the spread between their reduced funding rate and the competitive market rate. This mechanism leads to a crowding-out of direct market finance and real effects for bank borrowers at the intensive margin: banks protected by bailout guarantees induce their borrowers to leverage excessively, to overinvest, and to conduct inferior high-risk projects. We confirm our model predictions using U.S. panel data, exploiting exogenous changes in banks' political connections, which cause variation in bailout expectations. At the bank level, we find that higher bailout probabilities are associated with more wholesale debt funding and lending. Controlling for loan demand, we confirm this effect on bank lending at the bank-firm level and find evidence on loan pricing consistent with a shift towards riskier borrower real investments. Finally, at the firm level, we find that firms linked to banks that experience an expansion in their bailout guarantees show an increase in their leverage, higher investment levels with indications of overinvestment, and lower productivity.

Convertible bonds were first introduced in China in 1998. Their popularity has risen in the past decades through various domestic regulatory reforms, as more and more companies came to recognize their advantages over conventional bond or equity issuances as ways to raise capital. In this paper, we study the role of convertible bonds in Chinese A-share listed companies’ decision to refinance, using data from 1999 to 2018. First, we find that firms with high information asymmetry tend to issue more convertible bonds than equities to mitigate financing cost, especially under the “Regulation of Restraining Non-public Issuance of Shares (NPIS)” launched in 2017, a regulation that retrains listed companies to issue shares non-publicly. Second, the introduction of “Breaking Rigid Redemption” policy, which breaks the custom of using rigid redemption clauses when financial institutes issue corporate bonds and asset management products, effectively promoted interest rate marketization in China and as a result, companies with a strong tendency to shift risks began to issue convertible bonds to reduce issuing cost after 2017. Third, regulatory requirements on the qualifications for companies played important roles in their refinancing choices. Lastly, we also find that SOEs in China are overall less sensitive to risk-shifting and information asymmetry, given their ample loan resources compared with non-SOEs. Our findings delineate the behaviors of Chinese A-share listed companies in their refinancing and explain the sudden surge in convertible bonds issuance since 2017.

The seminal works of Jensen and Meckling (1976) and Myers (1977) highlight the conflicts of interest between the owners, managers, and debt holders of the firm and discuss the risk-shifting behavior of the managers assumed for our purpose to be the“firm” in detriment of their debt holders. Although a considerable amount of research has been undertaken on this topic, much less studies are devoted to endogenizing risk choices in the presence of financial guarantees and in the context of corporate project financing. A firm risk’s appetite increases when it has a guarantee contract on its debt, which creates a conflict between the firm and the guarantee provider. Addressing formally this moral hazard issue, we propose an equilibrium model in which the borrowing firm and the guarantee provider pre-commit themselves to conscripted risk levels at the signature of the loan guarantee contract. We show if the borrowing firm and the guarantor precommit, the equilibrium risk level is lower than the one the firm will choose unilaterally. For short (long) maturity debts, both parties gain by agreeing on a high (low) risk project when the firm shareholders have a big equity stake in the new project. We also study the trade-off between the borrowing firm’s capital structure and its risk level. The optimal risk level of the firm is entirely determined by its ex-post capital structure.