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We consider a model of corporate finance with imperfectly competitive financial intermediaries. Firms can finance projects either via debt or via equity. Because of asymmetric information about firms’ growth opportunities, equity financing involves a dilution cost. Nevertheless, equity emerges in equilibrium whenever financial intermediaries have sufficient market power. In the latter case, best firms issue debt while the less profitable firms are equity-financed. We also show that strategic interaction between oligopolistic intermediaries results in multiple equilibria. If one intermediary chooses to buy more debt, the price of debt decreases, so the best equity-issuing firms switch from equity to debt financing. This in turn decreases average quality of equity-financed pool, so other intermediaries also shift towards more debt.

The choice of capital structure is one of the central issues in corporate finance. The cornerstone paper by Modigliani and Miller (1958) established that capital structure is irrelevant so long as financial markets are perfect. As financing decisions do matter in the real world, corporate finance literature has advanced a number of theories that show how various imperfections explain the observed patterns of capital structure. These explanations have mostly concentrated on the imperfections on the side of the firm: the optimal capital structure minimizes the costs borne by investors as a result of taxes, asymmetric information, conflicts of interest between management and shareholders, etc. Since the financial markets are assumed to be perfectly competitive, these costs are passed back to the firm in the form of a higher cost of capital, thus providing incentives to choose an optimal capital structure. In this paper, we study how the capital structure is affected by an imperfection on the side of financial markets. We assume that financial intermediaries have market power. There are many reasons to believe that financial markets are not perfectly competitive. Financial services require reputational capital; information accumulation and processing also create economies of scale and barriers to entry (Dell Ariccia et al., 1999). Morrison and Wilhelm (2007) argue that the increasing codification of certain investment banking activities have recently resulted in even greater scale economies in the investment banking business. Not surprisingly, after the Glass-Steagall Act was repealed in 1999, the global financial market has been increasingly dominated by a few “global, universal banks of new generation” (Calomiris, 2002) that provide both commercial and investment banking services (as well as other financial services). These banks also command a substantial market share in virtually all financial markets, including debt and equity issues. In 2007, according to Thomson Reuters (2008), the nine largest financial groups (Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citi, JP Morgan, Credit Suisse, Deutsche Bank, and UBS) controlled more than 50 percent in every major financial market; in many markets the top five financial intermediaries controlled up to 70 percent of the market. It is too early to judge the effect of the 2008 crisis on the financial market structure but it has certainly increased the remaining top banks’ market shares. Morrison and Wilhelm (2007) cite Securities Data Corporation’s data to show that the top five (top ten) banks’ share in the US common stock offering rose from 38 percent (62 percent) in 1970 to 64 percent (87 percent) in 2003. These trends have not been unnoticed by policymakers and academics. In 1999, the US Department of Justice launched an antitrust investigation on the IPO fees (Smith, 1999). The academic debate on the collusive nature of the clustering of the IPO fees is not conclusive (see Chen and Ritter, 2000 who argue that the fees’ clustering around 7 percent in the US is a sign of tacit collusion and Torstila, 2003 for cross-country evidence and the summary of the debate). Yet, the very nature of this debate suggests that the investment banking industry is not perfectly competitive. This conjecture is also consistent with the legal analysis by Griffith (2005) who argues that underwriters possess market power and use it for price discrimination. Why does imperfect competition matter for capital structure? Once the financial intermediaries start to behave strategically, the logic of conventional capital structure theories falls apart. Under perfect competition, the investors’ costs are passed onto the firm because investors earn zero rents on all financial instruments. In this paper, we still assume that investors are perfectly competitive, but the intermediaries between investors and firms are oligopolistic. Therefore, financial intermediaries receive positive rents; these rents may differ for debt and equity investments. Since firms choose capital structure depending on their privately known growth opportunities, intermediaries can use capital structure as a means of the second degree price discrimination (similarly to using monetary and barter contracts in Guriev and Kvassov, 2004). The purpose of discrimination is to extract higher fees from more profitable firms. We find that equilibrium capital structure is different in competitive and concentrated markets. For expositional clarity, we assume away all possible costs of debt financing. In this case, in line with the pecking order theory, debt crowds out equity as long as financial markets are sufficiently competitive. However, as markets become more concentrated, equity financing does emerge in equilibrium. Concentration of market power results in a substantial wedge between the oligopolistic interest rate and intermediaries’ cost of funds. Hence, there is a pool of firms that would borrow at rates which are below the market interest rate on debt but still above intermediaries’ cost of funds. In order to serve these firms without sacrificing revenues from lending at a high rate to existing borrowers, intermediaries use capital structure as a screening device. The better firms still prefer debt, while the less profitable firms are happy to issue equity. Therefore, the model is consistent with the observed increase in concentration in investment banking and the rise of equity issues worldwide in recent years. What makes our paper more than just another model of capital structure is the study of strategic interaction that results in multiple equilibria. As we show, these equilibria differ in terms of both capital structure and asset prices even though all agents are fully rational. This in turn provides a very simple rationale for stock market volatility, bubbles and crashes without resorting to assumptions on bounded rationality or limits of arbitrage. The intuition for multiplicity of equilibria is the strategic complementarity of portfolio choices by the financial intermediaries.1 Suppose that one intermediary decides to move from debt to equity. This raises the interest rate on debt so that some firms that used to borrow can no longer afford debt finance. These firms switch to equity which improves average quality of the pool of equity-financed firms (all debt-financed firms are better than equity-financed ones). This makes equity investment more attractive so other investors also choose to shift from debt to equity. We show that multiple equilibria do exist for a range of parameter values. Our analysis has two main empirical implications. First, ceteris paribus both across countries and over time, a higher concentration of financial market power should result in a greater reliance on equity finance. Second, there may emerge multiple stable equilibria; in each equilibrium stock prices are based on fundamentals, and investors buy debt and equity based on their rational beliefs. Hence, either equilibrium is not a temporary bubble but is sustainable in the long run. Our theory predicts that multiple equilibria emerge only in the intermediate ranges of concentration of the financial market power. If markets are perfectly competitive, there is a unique equilibrium where debt finance prevails; if markets are very concentrated, there is only one equilibrium with a high share of equity financing. Both predictions, however, are hard to test as there are many other determinants of capital structure that are correlated with changes in concentration of the financial markets. In particular, the cross-country test of our hypothesis is problematic as legal protection of outside shareholders in the US results in a widespread use of equity even though the US financial markets are very competitive (La Porta et al., 1998). As for the within-US experience over time, it is rather consistent with our results: the consolidation of financial industry in 1990s was accompanied by a growth in equity finance and in higher stock market volatility. In any case, finding appropriate instruments or locating a suitable natural experiment is a subject for future empirical work. Related literature. Market concentration is not the only explanation for the coexistence of debt and equity under asymmetric information. In the pecking order literature equity finance may emerge in equilibrium either if debt is costly or if information production is endogenous. In Bolton and Freixas (2000), both bank loans and public debt coexist in equilibrium with equity. Although equity financing involves a dilution cost, it still emerges in equilibrium since debt financing is also costly. Banks need to raise funds themselves and, therefore, bear intermediation costs, while bond financing involves inefficient liquidation. Since dispersed bondholders cannot overcome the free-rider problem, they are less likely to be flexible ex post (unlike banks). Again, each firm chooses the capital structure which is the least costly one for the investors since the perfect competition in financial markets translates investors’ costs into a higher cost of capital for the firm. Other potential costs of excessive leverage include costs of bankruptcy and agency costs of debt (Bradley et al., 1984). Cooney and Kalay (1993) consider the case of asymmetric information about both mean and volatility of the project returns; equity finance emerges in equilibrium. In Boot and Thakor (1993) and in Fulghieri and Lukin (2001), equity issues provide incentives for investors to produce information, hence bringing stock price closer to fundamentals and increasing issuer’s revenues. Our model is based on the pecking order theory of capital structure (Myers and Majluf, 1984). There is no consensus in the literature whether the pecking order theory outperforms the other explanations of capital structure, the trade-off theory and the agency theory. The empirical literature produces controversial results (see e.g. Myers, 2001, Baker and Wurgler, 2002, Mayer and Sussman, 2004, Welch, 2004 and Fama and French, 2005). It would probably be safe to say (see e.g. Fama and French, 2002 and Leary and Roberts, 2007) that a simple pecking order theory is certainly outperformed by the “complex pecking order theory” which incorporates features of the other theories. While we use the original pecking order theory as a point of reference, our results certainly extend to more general setups (see Sections 4 and 5). Moreover, our analysis shows that even the simple pecking order theory may be consistent with the data once the imperfect competition in financial markets is taken into account. Once the perfect competition assumption is relaxed, equity is issued even in this simple setup with all potential costs of debt financing assumed away. While most of the capital structure literature studies perfectly competitive financial markets, there are a few papers that focus on imperfect competition. Petersen and Rajan, 1994 and Petersen and Rajan, 1995 consider a model of a monopolistic creditor that performs better than competitive market because it is able to form long-term ties and internalize the debtor’s benefits from investment. In many ways, this arrangement is similar to our equity financing (which also emerges in highly concentrated markets). Faulkender and Petersen (2006) also focus on the imperfections on the market’s side and show that underleverage may be related to rationing by lenders rather than to firms’ characteristics. Neither paper, however, considers oligopoly and therefore does not describe the effects of strategic interactions. The paper by Degryse et al. (2009) also studies imperfect competition in banking and focuses on the interaction between organizational structure and the imperfectly competitive equilibrium. Our setup is similar but we focus on the interaction between debt and equity markets while Degryse et al. only consider lending. There is also a literature on market microstructure (e.g. Brunnermeier, 2001, ch. 3) that explicitly models the competition between market makers in financial markets. Our setting is most similar to Biais et al. (2000) who consider oligopolistic uninformed market makers screening informed traders. However, the market microstructure models study a single financial market while we focus on the situation where financial intermediaries interact strategically in two markets (debt and equity) using capital structure to screen firms. Our paper is also related to the literature on bubbles and crashes, as well as the one on the IPO waves. While our model does not describe bubbles (defined as deviations of stock prices from their fundamental values), we do show that there are multiple equilibria with different stock returns and volumes of stock issued; in this respect our paper is similar to Abreu and Brunnermeier (2003) who explain persistent bubbles by strategic interaction between rational arbitragers over time. Also, our model provides a rational explanation for the widespread market timing; the fact that firms issue equity when stock price is high and repurchase when low (Baker and Wurgler, 2002) can be explained by multiplicity of equilibria. The rest of the paper is structured as follows. In Section 2 we set up the model. In Section 3 we fully characterize the equilibria in a special case where the distribution of firms satisfies the monotone hazard rate condition; we show that if market structure is sufficiently concentrated there may be two stable equilibria: one with both debt and equity finance, and the other with debt finance only. We also consider an example without the monotone hazard rate condition where there are multiple equilibria with equity. Section 4 generalizes the model to the setting with agency costs and continuous choice of capital structure. Section 5 discusses further extensions. Section 6 describes empirical implications and concludes.

This paper studies a model of imperfect competition in financial markets with endogenous capital structure. The model builds on the pecking order theory of capital structure that assumes that firms are better informed about their growth opportunities than outside investors. An issue of equity sends investors a negative signal about the firm’s quality; the cost of equity financing is always higher than that of debt finance. Therefore, in the absence of the costs of financial distress the firms should finance their investment via internal funds or debt. Such a conclusion, however, hinges on the assumption that financial markets are perfectly competitive, so that all the imperfections of equity finance are automatically passed back to the firm in the form of a higher cost of capital. We show that when financial markets are concentrated, this does not have to be the case: returns on equity and debt may differ. In the presence of oligopoly in financial markets, some firms issue equity even if there are no costs associated with debt financing. The intuition is straightforward: oligopolistic financial intermediaries set interest rate on debt above their cost of funds. Hence, there are firms that would be financed in a perfectly competitive economy but who cannot afford to borrow under oligopoly. The intermediaries are happy to finance these firms but do not like to lower interest rates for their more profitable debtors. Capital structure emerges as an effective tool for the (second degree) price discrimination: the most profitable firms prefer to be financed via debt rather than switch to equity. An important implication of our analysis is the multiplicity of equilibria due to strategic interaction between oligopolistic financial intermediaries. The intermediaries’ portfolio choices are strategic complements: if one intermediary moves from debt- to equity-holding, others find it profitable to follow. When a large intermediary reduces lending and invests more in equity, the interest rate on debt goes up. Hence, some firms that used to be financed via debt have to switch to equity financing. As the marginal equity-financed firms are always better than the average equity-financed firms, this improves the expected returns on equity. Therefore investing in equity becomes relatively more attractive to other investors as well. The strategic complementarity also results in multiplicity of equilibria. It is important to note that there are no bubbles in the model: investors price each stock based on the rationally updated expectations of this stock’s returns. However, the returns are endogenous and are not uniquely determined given the multiplicity of equilibria. Our model suggest that there can be multiple equilibrium levels of stock prices based on fundamentals – and, therefore, sustainable in the long run. In order to fully explore the stock price dynamics a multi-period setup is needed, which is an exciting avenue for further research. While we develop implications for the multiple equilibria in a public stock market, our model if taken literally is a model of an entrepreneur raising capital for a new project. While our intuition is not constrained to this case, a few formal extensions are due to make the argument more convincing: first, one would need to consider the case with assets in place prior to raising new funds, second, consider secondary markets for stocks, and third, introduce a conflict between management and initial shareholders (see Dybvig and Zender, 1991 for the implications of the latter for the validity of the pecking order theory).