Information Asymmetry, Line of Credit and Term Loan Pricing

Abstract

The information asymmetry between the borrower and the lender is a well-studied issue in the credit contracts. Various mechanisms (credit rationing, short-term debt, relationship banking, collateralization) have been discussed in the literature to reduce the asymmetry. This paper examines the role of credit line in reducing the information asymmetry through better risk profiling of the borrower. A two period model followed by empirical evidence shows the information effect of credit line on term loan pricing. The empirical findings show that the presence of credit line correlates with better term loan pricing while the discontinuation of it correlates with the deterioration of term loan pricing. The interrelation of information asymmetry and contract stringency ascertains the efficacy of credit line contract in reducing information asymmetry. The paper further shows that the information effect from the LoC to term loan pricing is not incorporated in the loan rating, is not due to miscalculation of the cost of borrowing, is independent of whether the LoC and term loan has a shared lead arranger, stays significant in the presence of relationship loans, and not captured in the credit line utilization.