Modeling Put-Option Margin and Default Risk
When Labor Has a Voice in Bank Governance Mechanism
CHUEN-PING CHANG1, JYH-JIUAN LIN2* AND JENG-YAN TSAI3
1
Graduate Institute of Commerce Kaohsiung University of Applied Sciences
cpchang@cc.kuas.edu.tw 2* Department of Statistics Tamkang University 117604@mail.tku.edu.tw 3
Department of International Trade Tamkang University
tsaijy@mail.tku.edu.tw TAIWAN
Abstract: This paper demonstrates how labor voice determines the optimal bank interest margin and default risk decisions. Our model is based on a regime giving corporate governance power to current labor and then labor’s objective is equivalent to minimizing the equity value of the put option. We show that the governance voice pushes bank interest margin determination toward shareholder value maximization. However, an opportunity cost of bank governance from listening labor voice is increasing the bank’s default risk in equity returns.
Keywords: Bank Interest Margin, Default Risk, Labor Voice, Put Option
1 Introduction
In their paper on “When Labor Has a Voice in Corporate Governance,” Faleye, Mehrotra, and Morck (2006) show that labor-controlled publicly traded firms deviate more from equity value maximization, invest less in the long-term assets, and take fewer risks. Furthermore, they propose that labor uses its corporate governance voice to maximize the combined value of its contractual and residual claims, and that this often pushes corporate policies away from, rather than toward, shareholder value maximization. The principal advantage of their approach explains why labor-controlled firms are allowed to make their corporate governance voice decisions, but not their own operating (price and output) decisions, which may not be consistent
* Corresponding Author.
with banking firm literature. The rational is that labor voice creates an entrenched workforce with bank governance power. Entrenched labor, like entrenched bank operations management, can distort value as it strives to maximize its benefit. Moreover, like entrenched management, entrenched labor cannot be gotten rid of easily. This is a dark side from labor voice as argued by Jensen and Meckling (1979). In other words, we still know very little about how bank governance from labor voice affects interest margin and related default risk determinations.
The purpose of this paper is to address precisely this question. We find that bank governance from high labor voice earns high margin and sequentially high default risk. Inconsistent with Faleye, Mehrotra, and Morck (2006), this paper argues that bank governance from high labor voice
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pushes interest margin determination toward shareholder value maximization. The opportunity cost of high labor voice makes the bank take high risks in its equity returns.1
2 The Model
A. Concept
The model is designed to capture in a minimalist fashion the following characteristics of a bank with labor voice governance.
First, employee equity block holdings of the bank create an entrenched workforce with bank governance power. Like entrenched management in lending activities, entrenched labor cannot be ignored. This labor governance is associated with significantly depressed risk-taking since loans are long-term and risky because they are subject to non-performance.
Second, in general, labor does not gain bank control rights without acquiring an equity stake, for example, in the United States (see Faleye, Mehrotra, and Morck, 2006). However, if other shareholders’ stakes are small, as is often the case in large U.S. banking firms, equity ownership might give labor a bank governance voice out of proportion to equity block holding. For simplicity, labor equity holding of the bank is ignored.
Third, as long as the bank’s value exceeds the value of labor’s claim in bankruptcy, the value of labor’s earnings (contractual claims) is invariant to bank
1
Labor voice is the explicit treatment of the put-option pricing valuation in our paper. In bank operations management with labor voice governance, the earning-asset portfolio reallocation is inevitable. Results to be derived from our model do not extend to the case where the default-free asset is the swapped high-yield bond (see Lee and Cheng, 2008). Further, the borrower acceptance in risky lending is not explicitly taken into account in our paper Asosheha, Bagherpour, and Yahyapour, 2008). Our results do not extend to this particular case either.
value.
Fourth, we apply Merton’s (1974) model by explicitly linking the risk of the bank’s default process to the variability in the bank’s loan value and viewing the market value of the bank’s equity as the put option on the market value of the bank’s loans with strike price equal to the net promised payment of bank liabilities for labor’s objective. We propose to incorporate a labor voice in bank governance on the market value of the bank’s loan asset for triggering default only at maturity.2 As a result, the put option is proposed to model the bank’s equity value (which labor seeks to minimize), and the default can be calculated from the put option pricing model.
B. Framework
We consider a single-period ( t∈[0,1] ) put option model of a banking firm. At t =0 , the bank accepts D dollars of deposits and provides depositors with a rate of return equal to riskless market rate RD . Equity capital K held by the bank is assumed to be tied by regulation to be a fixed proportion q of the bank’s deposits; that is K ≥qD . The required capital-to-deposits ratio q is assumed to be an increasing function of the amount of the loans L held by the
2
Black and Cox (1976), Brochman and Turtle (2003), and Chou and Wang (2007) point out one possible weakness of this approach used in our model that default only occurs at maturity of the debt. They propose to incorporate a barrier on the market value of firms’ asset for triggering default prior to the maturity. As a result, the down-and-out option is proposed to model the firm’s equity value, and the default risk can be formulated from the down-and-out option pricing model. Of course, the down-and-out approach can be applied to our setting. However this alternative is not addressed here. What this paper does demonstrate is the important role played by labor voice in affecting bank governance under the put-option-based equity valuation.
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indirect opportunity cost of a higher bank margin (bank equity return) is associated with a higher default risk in the bank’s equity return. Both the direct ineffective management and the indirect opportunity cost make the bank take on greater risk.
4 Conclusion
The results imply that changes in the bank governance voice have a direct effect on the bank’s profits and risks. We show that a long-standing labor voice in bank governance is associated with increased the optimal bank interest margin and default risk in equity return in the put-option valuation. We argue that labor uses its corporate governance voice to minimize its equity in the put-option valuation, and that this often pushes the optimal bank interest margin
toward, rather than away from,
shareholder value maximization.
However, listening to labor voice has to pay the opportunity cost of default risk in the bank’s equity returns.
Acknowledgementttt ：：：： The second author’s research has been supported partially by a research grant from the
National Science Council
(97-2118-M-032-003).
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