Does Secondary Loan Market Trading Destroy Lenders’ Incentives?

Abstract

In this paper we investigate whether the secondary market trading of syndicated loans compromises the quality of bank lending practices. We compare the performance of borrowers of traded loans following the initial trading event against the performance of borrowers of nontraded loans following loan issuance. We also investigate whether the relative performance of traded versus non-traded loans varies with the reputation of the lead arranger of syndication and with loan purpose. We measure performance by borrowers’ accounting performance and default risk. For loans originated by reputable lead arrangers, we find evidence that borrowers of traded loans actually perform better than borrowers of non-traded loans do. Thus, loan sales appear to have a positive effect on reputable arrangers’ incentives to monitor and screen borrowers. For loans originated by lower reputation lead arrangers, we find some evidence that the performance of borrowers of traded loans is worse than that of borrowers of non-traded loans and that borrowers of traded loans engage in earnings management behavior. These results are consistent with breakdowns in due diligence by non-reputable arrangers on loans anticipated to be sold. We also document that restructuring purpose loans (loans with a primary purpose of takeover, LBO, MBO or recapitalization) perform worse relative to other loans, regardless of whether or not they are traded.