This paper develops a model to answer the question whether a bank should hold a share of the equity of a borrowing firm. The model shows that a small equity stake held by the bank can have a significant and positive impact on the lending relationship. The benefit of bank equity participation arises from the reduced ability of the bank to extract rents from the firm in multiple rounds of financing. This, in turn, improves the firm’s incentive to make investments in profitable projects that require future outside finance. The benefit is likely to be significant for small to medium size firms, growth firms, and firms with ongoing capital needs. The paper addresses, from a corporate finance perspective, the current debate about whether banks should be allowed to own equity stakes in corporations – and how large these equity stakes should be.

We investigate how corporate governance impacts firm value by comparing the value and use of cash holdings in poorly and well-governed firms. We show that governance has a substantial impact on value through its impact on cash: 1.00 of cash in a poorly governed firm is valued at only 0.42 to $0.88. Good governance approximately doubles this value. Furthermore, we show that firms with poor corporate governance dissipate cash quickly in ways that significantly reduce operating performance. This negative impact of large cash holdings on future operating performance is cancelled out if the firm is well governed.

Amy Dittmar, Jan Mahrt-Smith, Henri Servaes, International Corporate Governance and Corporate Cash Holdings, The Journal of Financial and Quantitative Analysis, Vol. 38, No. 1 (Mar., 2003), pp. 111-133