The design of bank loan contracts

The unique characteristics of bank loans emerge endogenouslyto enhance efficiency in a model of renegotiation between aborrower and a lender in which there is the potential for moralhazard on each side of the relationship. Firm risk is endogenousand renegotiated interest rates on the debt need not be monotonein firm risk. The initial terms of the debt are not set to pricedefault risk but rather are set to efficiently balance bargainingpower in later renegotiation. Loan pricing may be nonlinear,involving initial transfers either from the borrower to thebank or from the bank to the borrower.     

Firm Size Dependence in the Determinants of Bank Term Loan Maturity

Abstract:   We examine the hypothesis that firm size affects the sensitivity of bank term loan maturity to its underlying determinants. As borrower size increases, negotiating power with the lender and information transparency increase, while the lender is able to spread the fixed costs of loan production across a larger dollar value of the loan. We find strong evidence of firm size dependency in the determinants of bank term loan maturity and show that this is unrelated to syndication. Only large borrowers can manipulate bank loan contract terms so as to increase firm value.     

The choice between informal and formal restructuring: The case of French banks facing distressed SMEs

This empirical paper investigates the paths leading to the resolution of financial distress for a sample of small and medium-sized French firms in default, focusing in particular on their decisions between bankruptcy and informal (out-of-court) renegotiations. The procedure is depicted as a sequential game in which stakeholders first decide whether to engage in an informal renegotiation. Second, conditional on opting for renegotiation, the debtor and its creditors may succeed or fail in reaching an agreement to restructure the firm’s capital structure. We test different hypotheses that capture (i) coordination and bargaining power issues, (ii) informational problems, (iii) firm characteristics, and (iv) loan characteristics. The empirical implementation is based on sequential LOGIT regressions. First, we find that the likelihood of informal renegotiations increases with loan size and the proportion of long-term debt. These two results support the argument that size matters when deciding whether to opt for informal renegotiation. Second, the probability of a successful renegotiation decreases when (i) the bank in charge of handling the process is the debtor’s “main” creditor and when (ii) the firm is badly rated and its management is considered faulty. Third, the estimations show that collateral plays a significant role in the first stage of the renegotiation process. However, it does not impact the likelihood of success in reaching a renegotiated agreement. Finally, some banks are clearly better than others at leading successful renegotiation processes.     

Investment,agency conflicts,debt maturity,and loan guarantees by negotiation

We consider an irreversible investment, of which the sunk cost is financed by a finite-term debt after entering into an option-for-guarantee swap (OGS) with negotiation. The OGS is a three-party agreement among a lender (bank), an insurer, and a borrower (entrepreneur), where the bank lends at a given interest rate to the entrepreneur and if the borrower defaults on debt, the insurer must pay all the principal and remaining interests to the lender instead of the borrower. In return for the guarantee, the borrower must allocate a perpetual American call option to purchase a fraction (guarantee cost) of his equity at a given strike price. We find that the investment threshold decreases but the exercise threshold of the insurer’s option increases with the borrower’s bargaining power. Both the investment and exercise threshold increase with debt maturity, but there is a U-shaped relation between the guarantee cost and debt maturity. The borrower postpones investment once the funding gap or project risk increases. The swap may overcome the inefficiencies from asset substitution and debt overhang, strongly depending on the debt maturity and borrower’s bargaining power.     

The determinants of multiple bank loan renegotiations in Europe

This article provides empirical evidence on the determinants of multiple bank loan renegotiations in Europe over the last decade. It finds that renegotiations differ from those in the US in terms of frequency, amended terms, and first occurrence. Multiple renegotiations concern very large loans, which are funded by large pools of lenders with fewer lead banks. Borrower transparency and amendment characteristics halt the number of renegotiation rounds, while the credit crisis of 2008 has had the opposite effect. Financial development, banking structure, and creditor rights also influence the renegotiation process. Overall, the renegotiation process adapts to informational frictions in the borrower–lender relationship.     

The effects of bank relationships on firm private debt restructuring: Evidence from an emerging market

Our paper seeks to examine the direct benefit of bank relationships for a distressed borrower by assessing its influence on the success of firm private debt restructuring. We find that a distressed firm with a stronger bank relationship has a greater probability to successfully restructure its debt through private renegotiation. Accordingly, an analysis of credit rating recovery provides complementary evidence on the factors of successful debt restructuring. A duration analysis of the length of time needed for a debt restructuring to be completed is fully consistent with our documented results. We conclude that in a bank dominated financial system like Taiwan's where firms are heavily bank-dependent, the bank-firm relationship is of crucial importance to the success of financially distressed firms in private debt restructuring.     

Credit risk analysis with creditor’s option to extend maturities

We present a Merton (J Finance, 1974)-type structural model of credit risk in which the borrower firm refinances its debt, there is cost for bankruptcy, and the creditor has an option to extend the date of maturity of debt if the firm defaults. We show that a solution exists in such a model and in that solution the creditor has incentive to extend maturity to avoid bankruptcy cost. We solve the model numerically and argue that such maturity extension option for the creditor can have substantial impact on the debt and stock values of the firm.     

Tests of ex ante versus ex post theories of collateral using private and public information

Collateral is a widely used, but not well understood, debt contracting feature. Two broad strands of theoretical literature explain collateral as arising from the existence of either ex ante private information or ex post incentive problems between borrowers and lenders. However, the extant empirical literature has been unable to isolate each of these effects. This paper attempts to do so using a credit registry that is unique in that it allows the researcher to have access to some private information about borrower risk that is unobserved by the lender. The data also include public information about borrower risk, loan contract terms, and ex post performance for both secured and unsecured loans. The results suggest that the ex post theories of collateral are empirically dominant, although the ex ante theories are also valid for customers with short borrower–lender relations that are relatively unknown to the lender.     

Stock market illiquidity,bargaining power and the cost of borrowing

We show that firms with illiquid stock have higher syndicated loan spreads. This result is invariant to measurement of stock illiquidity, and is robust to a wide set of cross-sectional loan and firm features, firm and time fixed effects. It also holds using a matched difference-in-differences estimator, at an exogenous reduction in the minimum tick size of major United States exchanges, and using a two-stage least squares estimator. Stock illiquidity is shown to increase spreads more when a lead lender has a high market share or a borrower has a low credit rating. It increases spreads less when a borrower has public rated debt and it diminishes the benefit to the loan recipient of a lending relationship. Measurements of stock price informativeness and firm-level governance do not affect the stock illiquidity and loan spread relation. A rationale for these findings is that stock illiquidity impairs the bargaining power of corporate borrowers, in negotiating a loan rate, as it raises the cost of alternatively raising funds by issuing equity.     

Product Market Imperfections and Loan Commitments

I show in a model of competitive banks that the characteristics of loan contracts are affected by product market imperfections in the borrower's industry. A bank loan commitment increases the value of a borrower firm operating in an imperfectly competitive industry and thus dominates a simple loan even in the absence of risk sharing considerations and informational asymmetries between the borrower and the bank. While it is individually rational for a firm to obtain a loan commitment, all the firms in that industry taken together are made worse off by the existence of loan commitments.     

Bank Monitoring and Environmental Risk

Abstract:  Loan announcement effects for 152 Canadian companies are examined to investigate the efficiency of monitoring by banks facing lender environmental liability. Market reaction to the announcement of bank debt to 'environmental' firms is more positive and significant than for 'non-environmental' firms and, for firms in industries with a higher likelihood of experiencing spill events, is more positive and significant, reinforcing earlier results that establish a relationship between specific loan/borrower characteristics and announcement period excess returns and providing further evidence on the 'uniqueness' of bank loans by demonstrating the superior ability of banks to monitor corporate borrowers exposed to environmental liability.     

Credit rationing and non-price loan terms: A re-examination

This paper develops the implications of heterogeneous bank loans for borrower and lender behaviour in a competitive bank loan market by considering the own funds-loan ratio as the ‘non-price’ loan term. It is shown that in equilibrium each bank will ration its loan to borrowers by providing them with the smaller loan and requiring the higher own funds-loan ration than they would desire at the equilibrium loan rate. Moreover, restrictive monetary policy that raises the opportunity cost of granting loans decreases the loan size and increases the own funds-loan ratio, but its effect on the loan rate and credit rationing remains ambiguous. Thus credit rationing may decrease as a result of restrictive monetary policy.     

On debt service and renegotiation when debt-holders are more strategic

The contingent claims analysis of firm financing often presents a debt renegotiation game with a passive bank that does not use its ability to force liquidation strategically, contrary to what is observed in practice. We consider two motives that may lead a bank to refuse to renegotiate: maintaining its reputation to preserve its future lending activity and deterring firms from overstating their debt service abatement when they renegotiate. We show that with public information and private debt only, the optimal probability of debt renegotiation is high when the firm’s anticipated liquidation value is high. Under asymmetric information about liquidation value, the high liquidation value firm may be tempted to mimic the low liquidation value firm to reduce its debt service. To deter such mimicking, banks may sometimes refuse to renegotiate with firms having a low liquidation value.     

The Supply‐Side Determinants of Loan Contract Strictness

Using a measure of contract strictness based on the probability of a covenant violation, I investigate how lender‐specific shocks impact the strictness of the loan contract that a borrower receives. Banks write tighter contracts than their peers after suffering payment defaults to their own loan portfolios, even when defaulting borrowers are in different industries and geographic regions from the current borrower. The effects persist after controlling for bank capitalization, although bank equity compression is also associated with tighter contracts. The evidence suggests that recent defaults inform the lender's perception of its own screening ability, thereby impacting its contracting behavior.     

So what do I get? The bank's view of lending relationships

While many empirical studies document borrower benefits of lending relationships, less is known about lender benefits. A relationship lender's informational advantage over a non-relationship lender may generate a higher probability of selling information-sensitive products to its borrowers. Our results show that the probability of a relationship lender providing a future loan is 42%, while for a non-relationship lender, this probability is 3%. Consistent with theory, we find that borrowers with greater information asymmetries are significantly likely to obtain future loans from their relationship lenders. Relationship lenders are likely to be chosen to provide debt/equity underwriting services, but this effect is economically small.     

Debt contract strictness and auditor specialization

The conflicts of interest among managers, shareholders and creditors resulting in agency costs, can be mitigated by restricting managers’ adverse behavior, through financial covenants to better align the various stakeholder interests. Thus, debt contract strictness represents an important aspect of agency costs between creditors, shareholders, and management that is not always captured by interest rates. The contract setting provides a unique opportunity to investigate how creditors may rely on auditors to alleviate information uncertainty stemming from reliance on management's financial reporting and thus alleviate the creditor's potential loss of invested capital. After controlling for borrower risks, loan characteristics, and audit factors, we show that auditor industry specialization is significantly associated with a reduction in the strictness of debt contracts, consistent with creditors viewing certain industry expert auditors as effective monitors against financial reporting manipulation aimed at the avoidance of debt covenant triggers that protect creditors against potential loss. Further, we find that the association between loan strictness and auditor specialization is attenuated by stronger corporate governance systems, external monitors, and prior lender relationships.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.     

Information asymmetry,external certification,and the cost of bank debt

This paper examines how the cost of bank debt reflects public information about borrower quality, and whether such information complements or substitutes the private information of banks. Using a sample of small business loans, and the award of a competitive public subsidy as an observable positive signal of external certification, we find that certification is associated with a lower cost of debt for subsidy recipients if the amount of private information of the lender is limited or the local credit market is less competitive. Public information loses importance once the bank accumulates information over the course of the lending relationship or the credit market is more competitive. Our results highlight a positive effect of external certification, driven by the signal it provides to both the lending bank and its competitors, and suggest that public and private information can be substitutes in the pricing of bank debt.     

Corporate Debt Value,Bond Covenants,and Optimal Capital Structure

This article examines corporate debt values and capital structure in a unified analytical framework. It derives closed-form results for the value of long-term risky debt and yield spreads, and for optimal capital structure, when firm asset value follows a diffusion process with constant volatility. Debt values and optimal leverage are explicitly linked to firm risk, taxes, bankruptcy costs, risk-free interest rates, payout rates, and bond covenants. The results elucidate the different behavior of junk bonds versus investment-grade bonds, and aspects of asset substitution, debt repurchase, and debt renegotiation.     

The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in the United States and model bankruptcy as a strategic decision. We analyze a firm's choice between liquidation under Chapter 7, renegotiation of the debt contract in a workout, and reorganization under Chapter 11 of the bankruptcy code. Our premise is that a financially distressed firm chooses its action in order to minimize the loss in value caused by the well-known over- and under-investment problems. We show that the firm initiates a workout when it faces under-investment, and commences Chapter 11 when it faces over-investment. Some of the results are: (i) in default, total firm value and equity value increase upon the announcement of a workout and decrease upon the announcement of Chapter 11; (ii) firms with shorter maturity of debt are more likely to reorganize in a workout; (iii) among the firms that renegotiate their debt contract, the proportion of firms entering Chapter 11 is higher for firms in mature industries than for firms in growth industries.