Assoiate Professor Jianai PI PhD Department of Eonomis Shool of Business Nanjing University E-mail: jianaipi@hotmail.om; pi28@nju.edu.n THE CHICE BETWEEN THE MAL AND ELATINAL INANCING IN CHINESE AMILY IMS Abstrat: This paper mainly disusses the owner-managers hoie between the formal and relational finaning in Chinese family firms. In order to seek some kind of rent resulting from moral haard and limited liability the owner-managers of family firms have the inentive to adopt appropriate finaning mode. ur theoretial analyses show that under some onditions it is indifferent for the owner-manager to hoose the formal finaning ontrat or the relational finaning ontrat while under other onditions it is optimal for the owner-manager to hoose the formal finaning ontrat or to hoose the relational finaning ontrat. Key words: ormal inaning elational inaning Moral Haard amily firm. JEL Classifiation: G32 L2 M2. Introdution China s private-owned enterprises espeially family firms play an important role in promoting China s eonomi performane (Whyte 995; Anderson et al. 23; Allen et al. 25). But during China s transition from the planning trak to the market trak there exist a lot of inevitable institutional problems suh as a lak of effetive apital market whih onstitute great obstales to the further development of family firms. amily firms eagerly need finanial support when they grow big while the formal finaning is limited to them. So there are many family firms whih have to resort to informal finane espeially seek the relation-based family irle for help whih is alled the relational finaning in this paper. Therefore the family firms owner-managers (also alled insiders or
Jianai PI borrowers ) faes the hoie between the formal and relational finaning provided by different types of investors (also alled outsiders or lenders ). How to make this hoie is an important question that should be answered for family firms. In order to seek some kind of rent resulting from moral haard and limited liability the owner-managers will try their best to adopt appropriate finaning mode. Aording to Tirole (26) there are several strands of theoretial literature on the miroeonomis of orporate finane. nly the first strand in Tirole s (26) sense is related to our paper. This strand fouses on the inentives of the owner-managers. The investors (also alled outsiders or lenders ) are in a prinipal-agent relationship with the owner-managers (also alled insiders or borrowers ). Informational asymmetries in this relationship an lead to many kinds of ageny problems suh as the well-known adverse seletion and moral haard. Just as Tirole (26 p.2) points out inanial ontrating in this stream of literature is then the design of an inentive sheme for the insiders that best aligns the two parties. The outsiders are viewed as passive ash olletors who only hek that the finanial ontrat will allow them to reoup on average an adequate rate of return on their initial investment. Beause outsiders do not interfere in management the split of returns among them (the outsiders return is defined as a residual one insiders ompensation is subtrated from profit) is irrelevant. In order to redue the degree of the owner-manager s moral haard there are many instrumental shemes that have been designed in the existing literature. Innes (99) examines the single-period finaning model in whih the borrower exerts hidden effort after he reeives finaning from the investor. Bolton and Sharfstein (99) and Hart and Moore (998) onsider the finaning model where the borrower s effort is observable but profits are unobservable and non-verfiable. Lawarree and Van Audenrode (996) study the finaning model with hidden effort unobservable output and some kind of adverse seletion. Holmstrom and Tirole (997) explore the finaning model where both the borrower and the investor are apital-onstrained. Povel and aith (24) examine the finaning model where investments are unobservable and profits are non-ontratible. Dang (2) fouses on the two-period finaning model with hidden effort unobservable profits and endogenous osts of effort. However to the best of my knowledge all the literature neglets the borrower s the hoie between the formal and relational finaning. In this paper we aim to fill this gap in the literature by studying the finaning model through an improved prinipal-agent framework. As a developing ountry China has different national onditions ompared to developed ountries. or example in China smaller firms tend to hoose relational
The Choie between the ormal and elational inaning in Chinese amily irms ontrats while larger firms tend to adopt formal ontrats in the ourse of their produing buying and selling and there are many fators that affet firms ontrating deisions (Hu and Qiu 2). we extend this thinking from the real eonomy to the fititious eonomy then what onlusion an draw from our analyses? We find a number of variables whih are important for Chinese family firms finaning deisions and some of them are greatly negleted by the existing literature. This onstitutes one of this paper s ontributions. The rest of the paper is organied as follows. Setion 2 is the basi setup. Setion 3 provides the model of the formal finaning ontrat. Setion 4 offers the model of the relational finaning ontrat. Setion 5 onduts a omparative analysis of the two different models. Some onluding remarks are made in Setion 6. 2. The Basi Setup In this setion we follow Innes (99) and Laffont and Martimort s (22) analytial framework. A redit-onstrained family firm needs a amount of I to finane its projet. The projet is subjet to moral haard. the owner-manager exerts effort level e {} the firm s added-value will be V with probability ( e) and V with probability ( e) where ( e). ( e) and ( e) an be seen as suess and failure probabilities respetively. When the family firm s performane is good the investor an get a ompensation ; however when the family firm s performane is bad the investor an only get a ompensation. The owner-manager is proteted by limited liability. That is to say V V. It is Sappington (983) and Innes (99) who introdue the onept of limited liability into finaning models. When the owner-manager exerts effort ( behaves or works ) his effort ost is =>. When the owner-manager exerts no effort ( misbehaves or shirks ) his effort ost is where <. The following mathematial definitions should be noted () = () = = > V = V V >.
Jianai PI There are two types of finaning modes that the owner of the family firm an hoose from either the formal or relational finaning. When the formal finaning is adopted the owner-manager borrows from a legitimate intermediary (e.g. a bank) whih is seen as the formal investor in this paper. We use the supersript to denote the formal finaning. Beause the finanial market environment in China is imperfet the owner-manager has to endure a institutional ost when he adopts formal finaning where >. In this ase = => and = = whih is similar to the assumptions of the traditional literature. When the relational finaning is adopted the owner-manager borrows from a informal intermediary (e.g. a family irle) whih is seen as the relational investor. We use the supersript to denote the relational finaning. In this ase = => and =. The reason why we set is that there is some kind of spiritual and psyhologial ost when the relation-based owner-manager shirks. Throughout the paper for the sake of narrative simpliity we all the uneasiness ost and the exertion ost. It is assumed that both the owner-manager of the family firm and the investor are risk-neutral. or both the formal and relational investors there are many potential borrowers who are redit-onstrained. That is to say we should have in mind that several prospetive borrowers ompete for borrowing from the formal investor or the relational investor whih an be supported by real-life evidenes in China. Empirial findings show that private Chinese firms (inluding family firms) are seriously redit-onstrained while state-owned and firms and foreign-owned firms in China are not (Ponet et al. 2). The timing of the prinipal-agent game is as follows. () At t= the formal investor or the relational investor offers a take-it-or-leave-it finaning ontrat {( I; )} to the owner-manager. (2) At t=2 the owner-manager hooses between the formal finaning ontrat and the relational finaning ontrat. (3) At t=3 the investor hooses whether to ineentivie the owner-manager or not. (4) At t=4 the owner-manager hooses an effort whih is or. (5) At t=5 the firm s added-value is realied.
The Choie between the ormal and elational inaning in Chinese amily irms (6) At t=6 the signed ontrat is enfored. 3. ormal inaning Contrat When it is under the formal finaning ontrat the formal investor s programming problem will be: max + ( ) I {( )} s. t. ( V ) + ( )( V ) ( V ) + ( )( V ) () ( V ) + ( )( V ) (2) V (3) () (2) and (3) are the owner-manager s inentive ompatibility partiipation and limited liability onstraints under the formal finaning ontrat respetively. Aording to the standard inentive theory it is easy for us to find that onstraint (3) is binding and that onstraint () is binding when onstraint (2) is binding when <. Solving this programming problem we obtain: and that then * * = V (4) = V (5) < then
Jianai PI * = V (6) * + = V (7) The supersript * stands for seond-best state under the formal finaning ontrat. Throughout the paper we use the seond-best in the sense that there is informational asymmetry between the investor and the the owner-manager whih hene an not produe the so-alled first best outomes under symmetri information. (4) (5) (6) and (7) show that there is no rent to the owner-manager when the family firm s performane is bad and that there is some kind of rent resulting from moral haard and limited liability to the owner-manager when the family firm s performane is good. U * then the owner-manager s equilibrium utility will be: = < then the owner-manager s equilibrium utility will be: (8) U = (9) * The subsript stands for the owner-manager of the family firm throughout the paper. or the sake of simpliity we assume that V max{ } whih an ensure that the formal investor hooses to inentivie the owner-manager. Through omparative statis we an obtain Proposition. Proposition : When it is under the formal finaning ontrat * U = * U = * U * U * * whether or <.
The Choie between the ormal and elational inaning in Chinese amily irms Proof: When then from (8) we obtain: = = * * * ( ) = 2 * = 2 ( ) E* = < * = <. When < then from (9) we obtain: = = = = = =. * * * * * * There are two points about Proposition that should be noted. irstly the owner-manager s equilibrium utility is weakly dereasing or non-inreasing in the institutional ost under the formal finaning ontrat. Seondly the owner-manager s equilibrium utility is weakly dereasing or non-inreasing in the exertion ost under the formal finaning ontrat. 4. elational inaning Contrat When it is under the relational finaning ontrat the relational investor s programming problem will be: max + ( ) I {( )} s. t. ( V ) + ( )( V ) ( V ) + ( )( V ) () ( V ) + ( )( V ) () V (2) () () and (2) are the owner-manager s inentive ompatibility
Jianai PI partiipation and limited liability onstraints under the relational finaning ontrat respetively. Aording to the standard inentive theory it is easy for us to find that onstraint (2) is binding and that onstraint () is binding when onstraint () is binding when <. Solving this programming problem we obtain: and that then * = V (3) = V * (4) < then * = V (5) * V = (6) The supersript * stands for seond-best state under the relational finaning ontrat. Similar to the ase under the formal finaning ontrat (3) (4) (5) and (6) show that there is no rent to the owner-manager when the family firm s performane is bad and that there is some kind of rent resulting from moral haard and limited liability to the owner-manager when the family firm s performane is good. then the owner-manager s equilibrium utility will be:
The Choie between the ormal and elational inaning in Chinese amily irms * U = (7) < then the owner-manager s equilibrium utility will be: U = (8) * or the sake of simpliity we assume that V max{ } whih an ensure that the relational investor hooses to inentivie the owner-manager. Through omparative statis we an obtain Proposition 2. Proposition 2: When it is under the relational finaning ontrat * U = * = * U * U * * < whether or. Proof: When then from (7) we obtain: P = = * * P P * ( + ) = 2 ( ) * G ( ) = 2 ( ) * = * = <. When < then from (8) we obtain: = = = = = =. * * * * * *
Jianai PI There are two points about Proposition 2 that should be noted. irstly the owner-manager s equilibrium utility is stritly dereasing in the relational ost under the relational finaning ontrat. Seondly the owner-manager s equilibrium utility is weakly inreasing or non-dereasing in the exertion ost under the relational finaning ontrat whih is ontrary to the ase under the formal finaning ontrat. 5. A Comparative Analysis In this setion we will ondut a omparative analysis between the outomes under the formal and relational finaning ontrats. By omparison it is easy for us to obtain the following three propositions. Proposition 3: When if < then it is indifferent for the owner-manager to hoose the formal finaning ontrat or the relational finaning ontrat; if < or owner-manager to hoose the relational finaning ontrat. then it is optimal for the Proof: When if < then from (9) and (8) we obtain: U U =. * * When if < then from (9) and (7) we obtain: U * * U =. When if then from (8) and (7) we obtain:
The Choie between the ormal and elational inaning in Chinese amily irms * * U U = = ( ). Throughout the paper we use the optimal in the sense that the owner-manager seeks to maximie his rent resulting from moral haard and limited liability. rom Proposition 3 we know that when the institutional ost is big enough relative to the uneasiness ost if the exertion ost is small enough relative to the uneasiness ost then the owner-manager s hoie is indifferent; and that if the exertion ost is moderate or big enough relative to the uneasiness ost then the owner-manager tends to hoose the relational finaning ontrat. Proposition 4: When < if < then it is indifferent for the owner-manager to hoose the formal finaning ontrat or the relational finaning ontrat; if < or owner-manager to hoose the formal finaning ontrat. then it is optimal for the Proof: When < if < then from (9) and (8) we obtain: U U =. * * obtain: When < if U U * * = When < if <. then from (8) and (8) we then from (8) and (7) we obtain: U U * * = = > rom Proposition 4 we know that when the institutional ost is small enough.
Jianai PI relative to the uneasiness ost if the exertion ost is also small enough relative to the uneasiness ost then the owner-manager s hoie is indifferent; and that if the exertion ost is moderate or big enough relative to the uneasiness ost then the owner-manager tends to hoose the formal finaning ontrat. 6. Conluding emarks In this paper we mainly disuss the owner-managers hoie between the formal and relational finaning in Chinese family firms through an improved prinipal-agent framework. In order to seek some kind of rent resulting from moral haard and limited liability the owner-managers of family firms will try their best to adopt suitable finaning mode. ur theoretial analyses show that under some onditions it is indifferent for the owner-manager to hoose the formal finaning ontrat or the relational finaning ontrat while under other onditions it is optimal for the owner-manager to hoose the formal finaning ontrat or to hoose the relational finaning ontrat. This kind of hoie an be seen as arbitrage whih aptures the rent differene in the formal and relational finaning. By introduing the oneption of the institutional ost under the formal finaning ontrat and the uneasiness ost under the relational finaning ontrat we an obtain different types of investors and owner-managers. The orresponding mathematial treatment method is greatly different from that of the existing literature whih may be used as a benhmark framework to deal with the similar questions in transition eonomies in the future. EEENCES []Allen. Qian J. Qian M. (25) Law inane and Eonomi Growth in China. Journal of inanial Eonomis 77() 57-6; [2]Anderson A.. Li J.-H. Harrison. T. obson P. J. A. (23) The Inreasing ole of Small Business in the Chinese Eonomy. Journal of Small Business Management 4(3) 3-36; [3]Bolton P. Sharfstein D. S. (99) A Theory of Predation Based on Ageny Problems in inanial Contrating. Amerian Eonomi eview 8() 93-6; [4]Dang V. A. (2) ptimal inanial Contrats with Hidden Effort Unobservable Profits and Endogenous Costs of Effort. Quarterly eview of Eonomis and inane 5() 75-89;
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