Banks, as formal financial institutions, perform governance duties in the context of lending. Among these duties, monitoring is one of the most significant (Freixas and Rochet 1997). Banks have comparative advantage in monitoring borrowers because they are considered as delegated monitors, conducting monitoring activities at a lower cost (Diamond 1984). Banks also benefit from economies of scale in monitoring and are leveraged in terms of access-to-borrower information unlike other financial intermediaries, such as individual lenders (Fama 1985). In general, banks conduct monitoring to avoid moral hazard, which arises from a borrower's opportunistic behavior, and so reduce their exposure to credit risk (Ahn and Choi 2009).
The loan syndication market has information asymmetry problems that lead to adverse selection and moral hazard problems. For syndicated lending, agency problems arise when the lead arranger or agent bank has information about a loan or the borrower that is not available to the participating lenders. This information could cover assessments of the borrower's management expertise, customer-supplier relationships, and the borrower's capacity to adapt to changing market conditions. Because of this, the lead arranger has an incentive to form a loan syndicate where the borrower's undisclosed information could put the participating lenders at a huge disadvantage (Dennis and Mullineaux 2000). Thus, the structure of loan syndicates can be thought of as an organizational response to agency or information asymmetry problems stemming from the syndication process (Pichler 2001; Godlewski 2008).
According to Sufi (2007), information asymmetry has a significant impact on the structure of syndicated loans and the composition of syndicate members that is consistent with moral hazard in monitoring. The author uses a theoretical framework based on models of agency and moral hazard (Holmstrom 1979; Holmstrom and Tirole 1997). This assumes that "informed lenders" conduct due diligence and monitoring on borrowers with limited public information before "uninformed lenders" participate in a loan syndicate. Here, the due diligence of informed lenders and their monitoring effort is not observable, leading to moral hazard problems.
To enhance the prospects for monitoring and ensure due diligence, Sufi (2007) argues that the lead arranger should retain a larger share of the loan because the arranger has governance responsibilities within the syndicate. The author notes that only a bank with a large financial stake in a loan that depends on the borrower's ability to pay exerts the necessary effort on governance. In other words, the lead arranger-the informed lender-is forced to maintain a large financial stake in the loan when the problem of information asymmetry is significantly high; that is, when the borrower requires intense monitoring and due diligence, given that the lead arranger's monitoring and due diligence effort is not observable. This is analogous to Brealey, Cooper, and Habib's (1996) argument that managers should take equity stakes in businesses to resolve problems of incomplete contracting and costly monitoring. Such a stake ties a manager's wealth to actions in cases where that wealth largely depends on the performance of the business in which the manager has an equity stake. This strategy, which associates a manager's "residual claimancy" with the ownership of equity, motivates the manager to perform well.
In the syndicated loan market, corporate borrowers who are subject to monitoring can get financing only after an informed lender takes a significant financial stake in the loan syndicate. This is supported by Lee and Mullineaux (2001), who find that lenders form more concentrated syndicates, with the lead arranger holding a large percentage of the loan, when there is less information about the borrower. Their result underscores the importance of the lead arranger enhancing monitoring within the syndicate. It also highlights the importance of "informed" capital for the financial health of firms that require more monitoring by a financial institution.