Do Banks Price Litigation Risk in Debt Contracting? Evidence from Class Action Lawsuits

Class action lawsuits can be detrimental to debtholders because they deteriorate defendant firms’ financial position and lower these firms’ value. This study examines whether banks price their borrowers’ litigation risk in debt contracting. We find that banks charge 19% higher interest spreads on loans to lawsuit firms after litigation. In addition, banks monitor lawsuit firms more closely by using tighter non‐price terms. The results are robust after correcting for possible endogeneity issues using the propensity score matching approach. We further find that the effects of lawsuit filing are more pronounced for firms with weaker corporate governance. Following a lawsuit in the industry, banks also perceive an increased likelihood of litigation for industry peer firms and adjust price and non‐price terms accordingly. Finally, we find that the magnitude of the lawsuit filing effect is greater for firms with lower ex‐ante litigation risk. Taken as a whole, our findings suggest that banks, as informed stakeholders, perceive litigation risk to be detrimental and price this risk in debt contracting.     

Corporate misreporting and bank loan contracting

This paper is the first to study the effect of financial restatement on bank loan contracting. Compared with loans initiated before restatement, loans initiated after restatement have significantly higher spreads, shorter maturities, higher likelihood of being secured, and more covenant restrictions. The increase in loan spread is significantly larger for fraudulent restating firms than other restating firms. We also find that after restatement, the number of lenders per loan declines and firms pay higher upfront and annual fees. These results are consistent with banks using tighter loan contract terms to overcome risk and information problems arising from financial restatements.     

Syndicated loan spreads and the composition of the syndicate

During the past decade, non-bank institutional investors are increasingly taking larger roles in the corporate lending than they historically have played. These non-bank institutional lenders typically have higher required rates of return than banks, but invest in the same loan facilities. In a sample of 20,031 leveraged loan facilities originated between 1997 and 2007, facilities including a non-bank institution in their syndicates have higher spreads than otherwise identical bank-only facilities. Contrary to risk-based explanations of this finding, non-bank facilities are priced with premiums relative to bank-only facilities in the same loan package. These non-bank premiums are substantially larger when a hedge or private equity fund is one of the syndicate members. Consistent with the notion that firms are willing to pay a premium when loan facilities are particularly important to them, the non-bank premiums are larger when borrowing firms face financial constraints and when capital is less available from banks.     

Do Banks Value Innovation? Evidence from US Firms

This study evaluates how innovation within companies alleviates the information asymmetry problems in relationship lending. We hypothesize that patenting activities could reveal favorable private information and, hence, reduce the information asymmetry between innovative borrowers and banks. Using a sample of US patenting firms from 1987 to 2004, we show that borrowers with higher innovation capability (revealed by having more patent applications, higher research & development (R&D) productivity, or higher‐quality patents) enjoy lower bank‐loan spreads and better nonprice‐related loan terms. Our evidence further suggests that the information benefits of patenting activities on loan spreads is more pronounced for small or less R&D‐intensive firms.     

Bank accounting conservatism and bank loan pricing

This paper studies the effects of bank accounting conservatism on the pricing of syndicated bank loans. We provide evidence that banks timelier in loss recognition charge higher spreads. We go onto consider what happens to the relationship between spreads and timeliness in loss recognition during the financial crisis. During the crisis, banks timelier in loss recognition increase their spreads to a lesser extent than banks less timely in loss recognition. These findings are broadly consistent with the argument that conditional accounting conservatism serves a governance role. The policy implication is that banks timelier in loss recognition exhibit more prudent and less pro-cyclical loan pricing behaviour.     

Monitoring and bank loan pricing

In this paper, we examine the influence of contract costs on the pricing of bank loans. We find that the loan spread depends on a bank's screening and monitoring incentives, which varies across differentially regulated classes of banks. This leads to significant price disparities in the loan market. In particular, the US branches of Japanese banks participate in syndicated lending to US firms that charge significantly higher spreads compared to syndicated loans to US firms without Japanese participation. This pricing disparity is primarily due to regulatory differences. We also find that as specialized intermediaries, banks price loans based primarily on their own monitoring.     

Borrowing during periods of policy uncertainty: The role of foreign lenders

Despite the documented detrimental effect of policy uncertainty on borrowing costs, there is no evidence on the potential role of cross border borrowings during such periods. In this study, we test two hypotheses on the potential role of foreign lenders during periods of high policy uncertainty. The first is the common exposure hypothesis, which predicts that domestic lenders pass their uncertainty exposure on to borrowing firms by charging higher loan spreads. Hence, foreign lenders without such exposure could be able to help dispel policy uncertainty. The second is the information cost hypothesis, which predicts that foreign lenders compensate for information asymmetry when lending in host countries by charging high loan spreads, which suggests potential higher costs of foreign borrowing. We find that foreign lenders who are not simultaneously exposed to policy uncertainty charge lower loan spreads than domestic lenders, which supports the common exposure hypothesis. Additional analysis reveals that the two hypotheses complement each other, as the documented effect is particularly pronounced for foreign lenders who are exposed to lower information asymmetry. The findings of the study shed some light on the role of financial market integration during periods of high policy uncertainty.     

Beauty is in the eye of the beholder: The effect of corporate tax avoidance on the cost of bank loans

We find that firms with greater tax avoidance incur higher spreads when obtaining bank loans. This finding is robust in a battery of sensitivity analyses and in two quasi-experimental settings including the implementation of Financial Accounting Standards Board Interpretation No. 48 and the revelation of past tax sheltering activity. Firms with greater tax avoidance also incur more stringent nonprice loan terms, incur higher at-issue bond spreads, and prefer bank loans over public bonds when obtaining debt financing. Overall, these findings indicate that banks perceive tax avoidance as engendering significant risks.     

CEO overconfidence and bank loan contracting

In this paper, we examine the effect of managerial overconfidence on bank loan spreads. Our theoretical model and empirical results support that firms with highly overconfident CEOs have lower loan spreads and that the reducing effect of these CEOs on the spread is more pronounced when the loan contracts have collateral or covenants. Unlike firms with highly overconfident CEOs, firms with moderately overconfident CEOs do not receive lower loan spreads. We perform various tests to alleviate the concerns about endogeneity, and the results are robust. The results are consistent with the idea that highly overconfident CEOs are more willing to pledge collateral and accept covenants in exchange for a reduction in their loan rate.     

Credit derivatives and bank credit supply

Credit derivatives are the latest in a series of innovations that have had a significant impact on credit markets. Using a micro data set of individual corporate loans, this paper explores whether use of credit derivatives is associated with an increase in bank credit supply. We find only limited evidence that greater use of credit derivatives is associated with greater supply of bank credit. The strongest effect is for large term loans—newly negotiated loan extensions to large corporate borrowers, with a largely negative impact on (previously negotiated) commitment lending. Even for large term borrowers, increases in the volume of credit are offset by higher spreads. These findings suggest that the benefits of the growth of credit derivatives may be narrow, accruing mainly to large firms that are likely to be “named credits” in these transactions. Finally, use of credit derivatives appears to be complementary to other forms of hedging by banks, though the banks most active in hedging appear to charge more for additional amounts of credit.     

Directors' and officers' liability insurance and loan spreads

We analyze the effect of directors' and officers' liability insurance (D&O insurance) on the spreads charged on bank loans. We find that higher levels of D&O insurance coverage are associated with higher loan spreads and that this relation depends on loan characteristics in economically sensible ways and is attenuated by monitoring mechanisms. This association between loan spreads and D&O insurance coverage is robust to controlling for endogeneity (because both could be related to firm risk). Our evidence suggests that lenders view D&O insurance coverage as increasing credit risk (potentially via moral hazard or information asymmetry). Further analyses show that higher levels of D&O insurance coverage are associated with greater risk taking and higher probabilities of financial restatement due to aggressive financial reporting. While greater use of D&O insurance increases the cost of debt, we find some evidence that D&O insurance coverage appears to improve the value of large increases in capital expenditure for firms with better internal and external governance.     

A Crisis of Banks as Liquidity Providers

Can banks maintain their advantage as liquidity providers when exposed to a financial crisis? While banks honored credit lines drawn by firms during the 2007 to 2009 crisis, this liquidity provision was only possible because of explicit, large support from the government and government‐sponsored agencies. At the onset of the crisis, aggregate deposit inflows into banks weakened and their loan‐to‐deposit shortfalls widened. These patterns were pronounced at banks with greater undrawn commitments. Such banks sought to attract deposits by offering higher rates, but the resulting private funding was insufficient to cover shortfalls and they reduced new credit.     

Explicit deposit insurance design: International effects on bank lending during the global financial crisis✰

Studies find that during the 2007–2009 global financial crisis, loan spreads rose and corporate lending tightened, especially for foreign borrowers (a flight-home effect). We find that banks in countries with explicit deposit insurance (DI) made smaller reductions in total lending and foreign lending, experienced smaller increases in loan spreads, and had quicker post-crisis recoveries. These effects are more pronounced for banks heavily relying on deposit funding. Evidence also reveals that more generous or credible DI design is associated with a stronger stabilization effect on bank lending during the crisis, confirmed by the difference-in-differences analysis based on expansion of DI coverage during the crisis. The stabilization effect is robust to the use of country-specific crisis measures and control of temporary government guarantees.     

Political connections and preferential lending at local level: Some evidence from the Italian credit market

We investigate the effect of political connections in Italy, for each level of government, on the credit markets and we find robust evidence that politically connected firms benefit from lower interest rates when the political link is at a local level. Our results show that this preferential treatment is stronger when connected firms borrow from banks with politicians on their boards and when the degree of autonomy granted to local loan officers is higher. The latter result provides a novel addition to the literature on the effects of the delegation of lending decisions within the bank. We also show that the effect is stronger in geographical areas where the incidence of corruption is higher. Overall, our results show that on aggregate the impact of political connections on interest rates is limited but it may rise significantly in specific (local) situations due to a combination of factors such as the delegation of lending decisions, a weaker rule of law and some governance characteristics of banks.     

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.     

Bankruptcy,overlapping directors,and bank loan pricing

Using a sample of loan facilities borrowed by firms that share directors with bankrupt firms, this study investigates whether the overlapping directors are a transmission channel of the bankruptcy contagion effect in the bank loan market and, if so, what the underlying mechanism is. We find that firms are charged higher loan spreads in the period following the bankruptcy filing of a firm with a common director and that overlapping directors are a relevant channel for the bankruptcy contagion effect, in addition to other channels identified in literature. We also find that the negative contagion effect on loan pricing is most likely driven by the overlapping directors' reputation loss due to their involvement in bankruptcy events, and not by competing hypotheses, such as director distraction and director career concern/experience. Further analyses reveal that the adverse contagion impact on loan spreads is more pronounced when overlapping directors have greater influence over corporate policies or when their reputation is more seriously damaged. Meanwhile, the contagion effect is mitigated when interlocked firms have a higher-quality board. These results further support our evidence of the director reputation loss hypothesis. We strengthen the identification strategy to establish causality. In sum, our study identifies common directors as a channel of bankruptcy contagion effects on loan pricing and director reputation loss as an underlying mechanism.     

Offshore operations and bank loan contracting: Evidence from firms that set up subsidiaries in offshore financial centers

We examine the effects of a multinational firm's subsidiary operations in offshore financial centers (OFCs) on bank loan contracting terms. Using a propensity score matched cross-country sample of firms with and without OFC subsidiaries, we find that firms with OFC subsidiaries receive less favorable loan terms than firms without OFC subsidiaries. The results from a difference-in-differences analysis and an analysis of a firm's mutation from a non-OFC firm to an OFC firm support the causal effect of offshore operations on the unfavorable loan terms. Furthermore, focusing on firms with OFC subsidiaries, we find that the intensity of offshore operations affects loan terms unfavorably. We also find that the unfavorable effect is more pronounced for more opaque firms and for firms that are headquartered in countries or jurisdictions with weaker legal enforcement. Our findings indicate that banks view offshore operations of borrowers as a credit risk-increasing factor.     

Monetary policy and bank risk-taking: Evidence from the corporate loan market

Our study of the corporate loan pricing policies of U.S. banks over the past two decades shows that loan spreads for riskier firms become relatively lower during periods of monetary policy easing compared to tightening. This effect is driven by banks with greater risk appetite, measured from individual banks’ answers to the Senior Loan Officers Opinion Survey. Our results hold with different fixed effects that account for time-varying observed and unobserved heterogeneity of credit demand and bank lending conditions that are not directly related to monetary policy. Together with our survey-based measure of bank risk appetite, we provide compelling evidence of the presence of a bank risk-taking channel of monetary policy in the U.S.     

Effects of international institutional factors on earnings quality of banks

We examine the relation between legal, extra-legal and political institutional factors and earnings quality of banks across countries. We predict that earnings quality is higher in countries with legal, extra-legal and political systems that reduce the consumption of private control benefits by insiders and afford outside investors greater protection. Using a sample of banks from 35 countries during the pre-crisis period from 1993 to 2006, we find that all five measures of earnings quality studied are higher in countries with stronger legal, extra-legal and political institutional structures. We also find that banks in countries with stronger institutions are less likely to report losses, have lower loan loss provisions, and higher balance sheet strength during the 2007–2009 crisis period. Our findings highlight the implications of country level institutional factors for financial reporting quality and are relevant to bank regulators who are considering additional regulations on bank financial reporting.     

Perceptions of corporate corruption culture and debt contracting

We find that the perception of corporate corruption culture in the top executive team affects both pricing and non-pricing loan provisions. Firms with higher levels of perceived corruption culture face higher interest spreads and are more likely to receive a collateral requirement. The bank syndicate is larger and more performance-based covenants and managerial negative restrictions (e.g., limits on capital expenditures or dividend restrictions) are put in place in loans made to firms with higher levels of perceived executive-based corruption. We further find that cultural proximity between lenders and borrowers mitigates the perceived corruption effects significantly, leading to contracts that are less costly and less restrictive. Additional tests suggest that lenders display an in-group bias in favor of culturally proximate borrowers.