Firm growth and type of debt: the paradox of discretion

According to agency theory, debt is a useful governance mechanism for curbing the tendency of managers to over-invest in firm growth. First, we extend this view by using the theory of rules versus discretion to explain why the ability of debt to constrain excessive growth is contingent upon lenders relinquishing discretion and committing to rigid rules. Next, we draw on the financial intermediation literature to distinguish between two types of debt. We explain that transactional debt (i.e. public securities such as bonds and commercial paper) conforms to a rules regime, and thus can serve as effective governance mechanisms for limiting the agency costs of over-investment in growth. In contrast, relational debt (i.e. private loans from financial intermediaries) is best characterized as a discretionary regime, and therefore is less effective in curtailing these agency costs. Paradoxically, it is the very intention of lenders to act optimally in the future that may result in this governance breakdown. Our empirical analysis of a large sample of Japanese firms confirms that the type of debt influences both firm growth and the performance consequences of that growth. Copyright 2010 The Author 2009. Published by Oxford University Press on behalf of Associazione ICC. All rights reserved., Oxford University Press.