External Governance and Debt Structure

This paper examines how external governance pressure provided by both the product market and the market for corporate control affects the type of debt that firms issue. Consistent with a governance mechanism substitution effect, we find that (i) an exogenous increase in governance pressure from the product market has a significant negative impact on the use of bank financing over public debt issuance, and (ii) an exogenous decrease in governance pressure from the takeover market has a significant positive impact on the use of bank financing. Tests using changes in the strictness of loan covenants provides corroborative evidence. We interpret these findings as consistent with the notion that firms endogenously substitute among alternative governance mechanisms in devising an optimal governance structure and that demand for creditor governance depends on the relative strength of alternative external governance mechanisms.