Institutional Liquidity Needs and the Structure of Monitored Finance

A financial institution that finances and monitors firms learns private information about these firms. When the institution seeks funds to meet its own liquidity needs, it faces adverse selection (“liquidity”) costs that increase with the risk of its claims on these firms. The institution can reduce its liquidity costs by holding debt rather than equity. Because these costs are passed through to borrowers, firms that depend on monitored finance generally prefer to give the monitoring institution debt rather than equity; an exception is a limited setting resembling venture capital. Institutions with less frequent or less severe liquidity needs have greater appetite for equity and for the debt of more risky borrowers. These predictions are consistent with general patterns of monitored finance. This is a substantial revision of an earlier paper entitled “Monitored Finance, Liquidity, and Institutional Investment Choice.” My research was supported in part by a grant from the Banking Research Center and by a First Chicago Research Chair, both at Northwestern University. I am grateful to John Boyd, Mark Carey, Peter DeMarzo, Doug Diamond, Gary Gorton, David Hirshleifer, Mike Fishman, Mark Flannery, Debbie Lucas, Raghu Rajan, Jaime Zender, and especially to Ravi Jagannathan and Maureen O’Hara (the editors) and two anonymous referees for comments and advice. I would also like to thank seminar participants at the 1997 WFA Meetings, the 1998 AFA Meetings, Boston College, London Business School, London School of Economics, Duke, Indiana, Northwestern, Ohio State, and Washington Universities, and the Universities of Maryland, Minnesota, Illinois, Michigan, Texas, and Washington for their comments.Address correspondence to Andrew Winton, Finance Department, Carlson School of Management, University of Minnesota, 321 19th Avenue South, Minneapolis, MN 55455, or email: [email protected]. Institutional Liquidity Needs and the Structure of Monitored Finance