What Determines the Design of Bank Loan Contracts? A New Channel

Abstract

I investigate whether uncertainties in bankruptcy procedures shape fi nancial contracting in the U.S. syndicated loan market. Utilizing a novel hand-collected data set, I exploit the application of substantive consolidation procedure, which is probably the most debated issue in U.S. bankruptcy courts. This procedure has two unique features: i) banks have unexpectedly large losses on their unsecured loans since in the court rooms the existing seniorities are removed, resulting in billion dollar allocation changes between the creditor groups; ii) since there is no specifi c provision in the U.S. Code, there is consensus in the law literature that this procedure has no theoretical background and its application is highly unpredictable. I conclude that after exposure, banks write more secured credit and tighter covenants in their new loans to other firms, even after controlling for bank capitalization, borrower and time fixed e ffects. To my knowledge, this is the fi rst paper to show that uncertainties in the bankruptcy procedures provide an important friction in the loan market. Moreover, my work complements the previous literature by providing a new channel for the determinants of optimal financial contracts. Results of this paper are also important for policy makers, who want to ease bank lending standards.