Do Information Rents in Loan Spreads Persist over the Business Cycles?

In this paper, we seek empirical evidence for information rents in loan spreads by analyzing a sample of UK syndicated loan contracts for the period from 1996 to 2005. We use various measures for borrower opaqueness and control for bank, borrower and loan characteristics and we find that undercapitalized banks charge approximately 34 bps higher loan spreads for loans to opaque borrowers. We further analyze whether this effect persists throughout the business cycle and find that this effect prevails only during recessions. However, we do not find evidence that banks exploit their information monopolies during expansion phases.     

Do Tighter Loan Covenants Signal Improved Future Corporate Results? The Case of Performance Pricing Covenants

Covenants in corporate bonds and loan agreements mitigate agency conflicts between borrowers and lenders and may provide a signal of borrower quality to help resolve information asymmetry. Performance pricing covenants in bank loans specify automatic adjustments to loan spreads based on borrowers’ subsequent performance. Our covenant signaling framework views interest‐decreasing performance pricing as a tight covenant associated with borrowers’ private information on improved future performance accompanied by reduced credit risk. This positive signal is associated with larger positive loan announcement returns and greater improvements in future borrower performance. Further, in addition to signaling value, we find that the spread impact of this class of covenant also depends on its option value and reduction in transaction costs.     

The cost of private debt over the credit cycle

We identify global and regional fluctuations in international private debt flows to emerging and developing countries using data on cross-border loans and international bond issuance over 1993–2009. We use micro-level data on syndicated cross-border loans and international bond placements to estimate the effects of individual borrower characteristics as well as macroeconomic conditions on the cost of foreign borrowing and test whether these effects differ across phases of the lending cycle. First, we find that borrower characteristics associated with lower loan spreads are not necessarily associated with lower bond spreads. Second, we find differential effects of borrower characteristics between cycle phases for loans and bonds separately. Third, we find strong reductions in the cost of debt finance during periods when international debt flows are more than one standard deviation above their mean, but not for expansionary periods, when the growth rate of debt flows is increasing. We also find that higher trade ratios in the borrower's home country raise loan spreads more in periods of high credit flows but have no effect on bond spreads. At the same time, borrowers residing in countries with high investment ratios pay lower spreads on bond issuance particularly during periods of high credit flows, but we find no similar effect for loan spreads. Inflation rates, real exchange rates and previous banking crises have small impacts on loan and bond spreads.     

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.     

Mortgage Default with Asymmetric Information

This article analyzes mortgage-market equilibrium when borrower default costs are private information. By applying the approach of Rothschild and Stiglitz (1976), it is shown that asymmetric information regarding default costs distorts the contract choices available in the mortgage market, preventing safe borrowers (those with high default costs) from fully satisfying their demand for mortgage debt. Large loans are available for a substantial interest-rate premium, but only risky borrowers find this premium worth paying. The article builds on an empirical literature designed to test the ruthless-default principle from option-based models of mortgage pricing. That literature provides evidence against ruthless behavior, suggesting that default costs play an important role in borrower decisions. The article takes a further step by arguing that such costs are private information, which has important implications for market equilibrium.     

Legal Restrictions in Personal Loan Markets

This study examines the pricing of personal loans in the form of second mortgages to determine whether state-specific default laws have an effect on the availability and cost of that debt. We examine the pricing of loans to higher risk borrowers and whether borrowers in states that limit lender ability to seek default remedies pay higher credit costs. Our results indicate that, for the most part, lenders rationally price loans to higher risk borrowers. However, when we focus on borrowers with low credit scores, the results indicate that mean actual loan rates are higher than those predicted by our model. The results also indicate that state-specific default laws have an effect on the price of credit. Finally, the results show that there is a greater degree of error in the pricing of second mortgage loans to borrowers with low credit scores than to borrowers with high credit scores.     

Borrower mobility, self-selection, and the relative prices of fixed- and adjustable-rate mortgages

This paper analyzes the effect of borrower self-selection between fixed- and adjustable-rate mortgages (FRMs and ARMS) on the pricing of FRMs. Self-selection occurs according to borrower mobility, with the most mobile borrowers favoring ARMS and less mobile borrowers choosing FRMs. The FRM interest rate depends on the average mobility of the FRM borrower pool, which determines the average duration of FRM loans. Comparative-static analysis of the equilibrium shows that any exogenous change that increases the relative attractiveness of FRMs enlarges the FRM borrower pool, which lowers its average mobility, shortens the duration of FRM loans, and thus reduces their price. Thus, an increase in the demand for FRMs actually reduces the FRM interest rate.     

Endogenous screening, credit crunches, and competition in laxity

A simple model of lending with endogenous screening predicts that risk-neutral banks tend to adopt tighter lending standards under several conditions commonly seen in recessions: lower interest rates (or spreads), higher default rates, or a smaller fraction of good borrowers. Historical data support these predictions. In addition, better information about borrower types encourages tighter lending standards, and competition in laxity can arise with multiple banks. Within the class of symmetric screening decisions, endogenizing the interest rates disrupts the existence of equilibrium in pure strategies, just as when screening decisions are assumed to be exogenous.     

Institutional Differences and International Private Debt Markets: A Test Using Mandatory IFRS Adoption

Institutional differences between countries result in additional information risks between borrowers and lenders in cross‐border private loans. This study examines the effect of these information risks on the structure of optimal debt contracts in international (cross‐border) versus domestic private debt markets. Using mandatory IFRS adoption as an indicator for institutional changes that reduced differences between countries, I compare attributes of international versus domestic loans before and after IFRS adoption. I find that, in the pre‐IFRS period, international loans are associated with a higher credit spread, a weaker relationship between the bank and the borrower, a more diffuse loan syndicate, and less reliance on accounting‐based covenants than domestic loans. These results are consistent with incremental information risks in international debt markets that make it more costly for lenders to screen and monitor borrower credit quality, resulting in a more arm's‐length relationship between borrowers and lenders. Many of these associations attenuate after IFRS adoption, suggesting that the pre‐IFRS differences in contract terms are driven by incremental information risks related to institutional differences between countries. My findings imply that incremental information risks result in a different optimal contract in international debt contracts compared to domestic debt contracts.     

Uncertainty and the Cost of Bank versus Bond Finance

How does uncertainty affect the costs of raising finance in the bond market and via bank loans? Empirically, this paper finds that heightened uncertainty is accompanied by an increase in corporate bond spreads, whereas spreads on bank loans remain unchanged. This finding can be explained with a model that includes costly state verification and in which banks maintain long-term relationships with borrowers and acquire information beyond what is publicly available. After an unexpected increase in uncertainty, the probability of borrower default increases. Banks leave the loan spread unchanged to maintain the relationship. In contrast, bond spreads increase because investors demand compensation for the increased default risk.     

Debt maturity dispersion and the cost of bank loans

This paper examines the relation between corporate debt maturity dispersion and the pricing and terms of bank loans. Analyzing a sample of U.S. bank loans from 2002 to 2016, we find that firms with a dispersed debt maturity structure pay a lower interest rate. The rate-reduction effect is significant only for firms without a credit rating. For these firms, spreading debt maturity dates also results in lower commitment fees, fewer covenant restrictions, and less collateral in their loan contracts. The impact of debt maturity dispersion on the pricing and structure of bank loans is stronger when borrowers have higher rollover risk or when the need for monitoring is greater. Our results suggest that dispersion in debt maturity structure mitigates the agency problem associated with shareholder–creditor conflicts by reducing rollover risk and alleviating the need for monitoring, which results in borrowers receiving more favorable terms in loan contracts.     

Risk-based pricing of interest rates for consumer loans

By focusing on observable default risk's role in loan terms and the subsequent consequences for household behavior, this paper shows that lenders increasingly used risk-based pricing of interest rates in consumer loan markets during the mid-1990s. It tests three resulting predictions: First, the premium paid per unit of risk should have increased over this period. Second, debt levels should have reacted accordingly. Third, fewer high-risk households should have been denied credit, further contributing to the interest rate spread between the highest- and lowest-risk borrowers.For people obtaining loans, the premium paid per unit of risk did indeed become significantly larger after the mid-1990s. For example, for a 0.01 increase in the probability of bankruptcy, the corresponding interest-rate increase tripled for first mortgages, doubled for automobile loans and rose nearly six-fold for second mortgages. Additionally, changes in borrowing levels and debt access reflected these new pricing practices, particularly for secured debt. Borrowing increased most for the low-risk households who saw their relative borrowing costs fall. Furthermore, while very high-risk households gained expanded access to credit, the increases in their risk premiums implied that their borrowing as a whole either rose less or, sometimes, fell.     

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.     

Is the Corporate Loan Market Globally Integrated? A Pricing Puzzle

We offer evidence that interest rate spreads on syndicated loans to corporate borrowers are economically significantly smaller in Europe than in the United States, other things equal. Differences in borrower, loan, and lender characteristics do not appear to explain this phenomenon. Borrowers overwhelmingly issue in their natural home market and bank portfolios display home bias. This may explain why pricing discrepancies are not competed away, though their causes remain a puzzle. Thus, important determinants of loan origination market outcomes remain to be identified, home bias appears to be material for pricing, and corporate financing costs differ across Europe and the United States.     

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.     

Financial Statements as Monitoring Mechanisms: Evidence from Small Commercial Loans

Using a data set that records banks’ ongoing requests of information from small commercial borrowers, we examine when banks use financial statements to monitor borrowers after loan origination. We find that banks request financial statements for half the loans and this variation is related to borrower credit risk, relationship length, collateral, and the provision of business tax returns, but in complex ways. The relation between borrower risk and financial statement requests has an inverted U‐shape; and tax returns can be both substitutes and complements to financial statements, conditional on borrower characteristics and the degree of bank–borrower information asymmetry. Frequent financial reporting is used to monitor collateral, but only for non–real estate loans and only when the collateral is easily accessible to lenders. Collectively, our results provide novel evidence of a fundamental information demand for financial reporting in monitoring small commercial borrowers and a specific channel through which banks fulfill their role as delegated monitors.     

BORROWING RELATIONSHIPS,MONITORING, AND THE INFLUENCE ON LOAN RATES

While monitoring borrowers, a bank obtains private information about its customers, giving the bank an informational advantage in the production of subsequent services. Competing theories exist on the way banks use this advantage in the pricing of subsequent services to the customer. If moral hazard limits the transfer of private information, the borrowing relationship transforms into an informational monopoly and can be characterized as a “wasting asset.” Alternately, if the banks' competitive environment necessitates that cost economies are shared, the relationship has “value.” Ordering pairs of successive loans made to a particular borrower as prior loans and subsequent loans, and controlling for environmental, borrower, and loan characteristics, we show that the subsequent loan is priced significantly lower than the prior loan.     

Consequences of Debt Forgiveness: Strategic Default Contagion and Lender Learning

I use a unique data set of loans to small business owners to examine whether lenders face adverse consequences when they grant debt forgiveness to borrowers. I provide evidence consistent with borrowers communicating their debt forgiveness to other borrowers, who then more frequently strategically default on their own obligations. This strategic default contagion is economically large. When the lender doubles debt forgiveness, the default rate increases by 10.9% on average. Using an exogenous shock to the lender's forgiveness policy, my findings suggest that as the lender learns about the extent of borrower communication the lender tightens its debt forgiveness policy to mitigate default contagion.     

PCAOB international inspection access and debt contracting: Evidence from American Depositary Receipt firms

We examine whether the Public Company Accounting Oversight Board’s (PCAOB’s) international inspection access affects the usage of accounting-based debt covenants in bank loan contracts of American Depositary Receipt (ADR) borrowers. We show that there is an increase in the use of financial covenants in debt contracts after the auditor of an ADR borrower becomes subject to PCAOB inspections. We also document that lenders increase the usage of financial covenants only in loans to ADR borrowers domiciled in countries with weak home country intuitions, and the increase is more pronounced for ADR borrowers from countries without a local auditor regulatory oversight body. These findings suggest that PCAOB regulatory oversight enhances the perceived credibility of accounting numbers for debt contracting and serves as a substitute for the weak monitoring of auditors for ADR borrowers domiciled in countries with weak country institutions.     

DO BANK RELATIONSHIPS MATTER IN PUBLIC DEBT OFFERINGS?

Finance theorists have argued that banks have a comparative advantage over public debtholders and other suppliers of debt both in gathering information about and in monitoring corporate borrowers. Although underwriters of public debt issues and private placements have access to inside information when executing specific transactions, commercial bankers have ongoing relationships with their corporate borrowers that have often been built up over years. Perhaps more important, banks are also often in a better position and have stronger incentives than a dispersed collection of bondholders to keep tabs on what the borrowers do after receiving the capital.
This theoretical argument received striking empirical support from a study by Chris James published in 1987 in the Journal of Financial Economics. Entitled "Some Evidence on the Uniqueness of Bank Loans," the study documented that announcements of new bank lending aggreements by public firms are received positively, on average (and in a large majority of cases) by the stock market. This finding offered a pointed contrast to the neutral to sharply negative stock-price responses that accompany announcements of almost all other kinds of securities offerings, including private placements of debt and public offerings of straight debt.
In this article, the authors discuss their own recently published study that provides another piece of evidence of the value added by banking relationships. Specifically, the authors report that the first public debt offerings of companies with bank relationships carry spreads that are 85 basis points less than the spreads of initial debt issues by comparable firms without bank relationships. As the authors interpret their findings, a banking relationship not only helps to "certify" the value of corporate borrowers to their stockholders, but also provides other lenders with valuable "cross-monitoring" benefits that are reflected in lower borrowing costs.