How does a bank's involvement interplay with a firm's capacity investment? An analysis and comparison of different consortium structures

• Author: Tsz Leung Yip,Kelly Yujie Wang,Yuan Wen,Meifeng Luo
• Date: 01 September 2020
• DOI: http://doi.org/10.1111/itor.12780
• Published date: 01 September 2020

Intl. Trans. in Op. Res. 27 (2020) 2658–2682

DOI: 10.1111/itor.12780

INTERNATIONAL

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IN OPERATIONAL

RESEARCH

How does a bank’s involvement interplay with a firm’s capacity

investment? An analysis and comparison of different

consortium structures

Kelly Yujie Wanga,∗,YuanWen

b, Tsz Leung Yipcand Meifeng Luoc

aBusiness School, Guangxi University, Nanning, China

bChina Development Bank, Nanning, China

cDepartment of Logistics and Maritime Studies, The Hong Kong Polytechnic University, Hung Hom, Hong Kong

E-mail: wyj.kelly@connect.polyu.hk [Wang];kenny.wen@qq.com [Wen]; t.l.yip@polyu.edu.hk [Yip];

meifeng.luo@polyu.edu.hk[Luo]

Received 6 January 2019; received in revised form 15 January 2020; accepted 20 January2020

Abstract

As nonrecourse project finance (rather than financing on a sovereign basis) is becoming more prevalent

worldwide, financing institutions have to collaborate more closely with firms to optimize capacity-investment

and financing decisions. Under this background, this paper presents a stylized Stackelberg games model,

taking into account the firm’s capacity investment as well as the bank’s interest rate and funding ratio

decisions. Consortium structures between bank and firm are formalized into five modes based on industry

practice, namely, the integrated consortium, pure shareholder funding, bank as leader, full coordination,

and bank as follower. The optimality and equilibrium of each of the five modes are analytically derived,

and their existence and uniqueness are demonstrated. Valuable economic insights are obtained throughboth

modeling analysis and numerical experiments, with the main findings including the following: (i) a lack of

bank financing leads to insufficient capacity investment and poor consortium performance; (ii) interest rate

and funding ratio play important butdifferent roles in the bank’s risk management; (iii) the bank’s proactivity

in leading and coordinating the consortium is critical for the two parties’ overall performance; and (iv) if the

bank is the follower, the firm’s capacity decision is irrelevant to the bank’s loan contract, and the consortium

cannot be coordinated to the first-best level of performance.

Keywords:capacity investment; Stackelberg games; consortium structures; project finance; interest rate; funding ratio

1. Introduction

This study addresses the issue of capacity investment. Since the global financial crisis of 2008,

there has been a prevalence of Keynesian economics worldwide in policymaking and industry

∗Corresponding author.

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K.Y. Wanget al. / Intl. Trans. in Op. Res. 27 (2020) 2658–2682 2659

practice (Giles et al., 2009). Following the easy money policy in the past decade, governmental

or quasi-governmental borrowings have accumulated and have played a major role in capacity

investment, especially in newly industrialized or developing countries (Bird, 2018). On the one

hand, with government support, a firm’s capacity investment can focus on operational issues and

there is seldom a need to worry about funding availability. On the other hand, financial institutions,

which are usually banks, generally rely upon government guarantees, and therefore, in these types

of recourse transactions, banks do not have to care much about market conditions, operational

strategy, or coordination with firms.

However, the situation is changing. An increasing number of transactions are being implemented

as limited or nonrecourse rather than recourse in public–private partnership (PPP) (including build–

operate–transfer) models (World Bank, 2018). For instance, the Chinese governmenthas proactively

promoted the PPP model since 2014 to ease the burden on heavily indebted local governments, as

well as to channel privatefunds to develop much needed investment for infrastructure or production

capacities. By the end of March 2019, there were 5541 commercial closed PPP projects in China,

totaling CNY 8.4 trillion (equivalent to US$ 1.2 trillion) in aggregate value (CPPPC, 2019). Such

PPP projects are nonrecourse, independent of any quasi-governmental or hidden governmental

guarantee, not to mention the various initiatives in an increasing number of newly industrialized

and developing countries that are attempting to tap into the potential of private investment rather

than relying solely on the credit of sovereign entities (Trebilcock and Rosenstock, 2015; Jomo et al.,

2016).

Overseas investment and multinational operations have further strengthened the above trend

and issues because firms and banks have to make operational and financial decisions in a business

environment characterized by more uncertainty and fluctuation. A good example is Chinese firms

and banks. Since the belt-and-road initiatives were proposed by the Chinese government at the end

of 2013, China’s outward foreign direct investment has seen rapid growth and now ranks second in

the world (UNCTAD, 2019). Chinese firms are investing and expanding their operations abroad,

especially in the fields of infrastructure and international production capacity cooperation. These

types of investment project usually have a long payback period and a high level of uncertainty.

Furthermore, firms and banks cannot pile up debt on the already heavily burdened host-country

government or Chinese shareholders. Instead, they can rely only on the cash flow generated from

the projects themselves. Substantial risks from construction, environmental and legal compliance,

and uncertain market demand affect the willingness of the firm to invest and the bank to lend.

Among those types of risk, market uncertainty is the first priority on which focus should be

placed.

These new trends have brought about new issues for firms and banks to address. For firms

facing volatile demand, especially in the overseas market, means that they should be prudent when

making a capacity-investment decision to match a predetermined capacity with a later realized

demand. In addition to the capacity decision, they have to take into account financing availability,

project cost, and interaction with banks. From the perspective of banks, they are also facing a

more flexible business environment along with greater fluctuations. First, apart from investigating

the sovereign risk, banks need to forecast market conditions, evaluate the commercial viability of

capacity investment, conduct due diligence and credit rationing on firms, take into account firms’

capacity-investment decisions, and try to avoidconstructing “white elephants.” Second, the interest

rate market is more flexible for nonrecourse project finance, granting more flexibility for banks.

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