The Cost of Easy Credit: Loan Contracting with Non-Bank Investors

Abstract

I study how the rise of non-bank loan investment from CLOs, mutual funds, and hedge funds influenced contracting relationships between firms and their senior lenders. Contrary to common perception that non-bank investors diluted the incentive for banks to monitor firms, I find evidence that bank underwriters embraced tighter contracts to mitigate agency and holdout problems associated with less-informed and dispersed non-bank investors. Using a novel measure for covenant tightness, I find that firms with non-bank loan funding had tighter covenants than otherwise similar firms with exclusively bank-funded loans at the peak of the credit cycle in 2007. Consistent with tighter covenant thresholds, I find that these firms were also more likely to renegotiate and violate covenants during the subsequent crisis. While recent studies show that non-bank loan investors lowered the cost and expanded the availability of capital ex ante, I conclude that tighter contracts assigned stronger control rights to lenders and imposed higher renegotiation costs to firms in a state-contingent manner ex post.