Monitored Finance, Liquidity, and Institutional Investment Choice

When agency problems require that an financial institution monitor the firms that it finances, the private information that it gathers about these firms harms the institution’s own liquidity. Dollar for dollar, debt is less risky and thus less sensitive to firm-specific information than equity, so holding debt improves the institution’s liquidity. If only partial monitoring is necessary, lowered risk may reduce the institution’s incentive to monitor, further improving its liquidity. However, if a firm’s initial prospects are poor, debt with reduced monitoring may lead to excessive liquidation; here, if feasible, the firm’s manager prefers equity with reduced monitoring. The preference for debt finance should be most pronounced for firms with limited access to public securities markets. Thus, the model predicts that debt or similar claims will dominate the portfolios of institutions that specialize in providing monitored finance. Among these institutions, those with greater liquidity needs should hold fewer monitored equity positions, make less risky loans, and monitor less intensively. These results are consistent with the general pattern of monitored finance and a number of cross-sectional institutional differences.