Governance mechanisms and bank interest margins: an examination of loan commitment with external financing

Abstract This paper examines the relationships among shareholder activism (internal governance), the market for corporate control (external governance), and the optimal bank interest margin. In an option-based model where the bank’s lending and deposit-taking may be two manifestations of one primitive function: the liquidity on demand provision, because the bank often lends via commitments, changes in internal and external governance mechanisms have direct effects on the bank’s optimal interest margin (and thus on the bank’s scale). The scale of the bank is increased (decreased) as a result of a larger number of takeover defense (offense) provisions when the bank realizes a less (more) risky state of the world. In such a scenario, we argue that the bank is required to use internal funds more (less) than raising external funds. Hence, governance mechanisms may produce significant changes in the relationships between bank behavior and the liquidity on demand provision.