Capital requirements, loan renegotiation and the borrower's choice of financing source

Abstract

The main objective of this paper is to theoretically examine the impact of bank capital requirements on a borrower's choice of financing source. Our focus is on the tension between regulatory taxes, such as bank capital requirements (that reduce the value of a bank loan to a borrower), and the bank's incentive to renegotiate debt terms with financially distressed borrowers (that increases the value of a bank loan to a borrower). We show that borrowers that approach banks are necessarily of intermediate quality. This set of borrowers diminishes as bank capital requirements increase. Surprisingly, this happens not only because bank capital requirements increase loan prices and hence reduce the value of the loan to the borrower, but also because they weaken the bank's incentive to restructure troubled loans, thereby causing a dampened loan demand. Additionally, holding quality fixed, growth-oriented borrowers are more likely to prefer the capital market than borrowers expecting high cash flows early when facing a sufficiently high capital requirement. Finally, the effect of capital requirement increases is asymmetric - growth-oriented borrowers are more likely than ‘cash cows’ to migrate from banks to the capital market when banks confront higher capital requirements.