Agency Costs, Bank Specialness and Renegotiation

Abstract

This paper proposes the yield spread between public bonds and bank loans of the same firm (the Bond-Bank spread) as a measure of compensation for agency costs that cannot be mitigated by bondholders but can be mitigated by banks due to their ability to monitor the firm and renegotiate the loan. In a model of debt pricing and choice, the tradeoff between firm moral hazard and bank opportunism, leads to co existence of relationship debt (bank loans) and uninformed debt (bonds) in its capital structure. Contrary to common concerns, bank oversight actually increases in the presence of bonds. Using a large and unique data set of bond and bank yields, for the same firm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral differences, it is shown that the Bond - Bank Spread is negative for high credit quality firms and positive for low credit quality firms, consistent with the theoretical model. Applying a new econometric methodology on matching developed by Heckman et al(1998), the results of the sample are confirmed. The Bond - Bank Spread is about -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or the specialness of banks seem to be important for BBB and below investment grade firms across the credit spectrum.