Guilt by Association? Creditor Rights and Industry Effects on Loan Terms

Abstract

This study examines the role of the borrower’s industry for loan terms in regimes with varying strength of creditor rights, efficiency of debt enforcement, and other institutional characteristics. We argue that the extent of borrower-lender agency conflicts affecting loan repayment will vary with the borrower’s industry, holding borrower-level characteristics constant. Therefore, in weak creditor rights environments the expropriation of creditors is both severe and is more heavily influenced by aggregate factors. As a result, in weak creditor rights regimes, lenders are going to be less willing to gather costly information about borrower-specific risk and more likely to use industry factors in setting loan spreads. The alternative hypothesis is that collection of firm-specific private information becomes increasingly important when creditors face significant agency conflicts and expropriation risks, resulting in more discriminate loan pricing, all else equal. Empirically, industry factors have a larger impact on loan spreads in countries with fewer creditor rights protections and weaker enforcement of creditor rights. The creditor rights effect is partially mitigated during high volatility periods associated with a greater aggregate level of uncertainty. When included jointly with other institutional characteristics, the effects of creditor rights and accounting disclosure quality dominate insider agency conflicts and government expropriation. The main result is also observed for loan size, indicating that the relevance of industry for the quantity, and not only the pricing, of bank loans depends on the creditor rights environment. We corroborate the identified patterns in the role of industry factors for loan pricing using US data on state variation in creditor protections. The findings have important implications for prospective borrowers whose cost of bank debt will be more affected by industry peers in poor creditor rights environments.