The effect of external governance on the choice between bank loans and public debt

This paper examines how external governance pressure provided by both the product market and the market for corporate control affects a borrowing firm’s choice of debt source. Using reductions in import tariffs to capture exogenous changes in a firm’s competitive environment, we find that increased product market competition has a significant negative impact on a firm’s reliance on bank debt financing. Using the passage of business combination laws that exogenously raised the costs of corporate takeovers, we find that decreased external governance pressure from the takeover market has a significant positive impact on the choice of bank financing over public debt issuance. We interpret this evidence as consistent with decisions about bank financing being driven by firm value maximization. We conclude that debt choice reflects the demand for creditor governance and is determined endogenously by the strength of alternative external governance mechanisms. Preliminary and incomplete for University of Mannheim research seminar May 18, 2015