Non-price Terms Research Articles

Lock-In Effects in Relationship Lending: Evidence from Dip Loans

Do prior lending relationships result in pass-through savings (lower interest rates) for borrowers, or do they lock in higher costs for borrowers? Theoretical models suggest that when borrowers experience greater information asymmetry, higher switching costs, and limited access to capital markets, they become locked into higher costs from their existing lenders. Firms in Chapter 11 seeking debtor-inpossession (DIP) financing often fit this profile. We investigate the presence of lock-in effects using a sample of DIP loans. We first account for selectivity bias by using the inverse mills ratio form a first stage. Then, in a second stage, we jointly estimate the relationship between loan price and non-price terms accounting for selectivity bias. We find that the existence and intensity of prior lending relationships are associated with higher interest costs, longer maturities, and smaller DIP loans. Taken together, our study provides direct evidence that prior lending relationships do create a lock-in effect under certain circumstances, such as DIP financing.

Does debtor protection really protect debtors? Evidence from the small business credit market

This paper analyzes how different levels of debtor protection across US states affect small firms’ access to credit, as well as the price and non-price terms of their loans. We use an individual-specific measure of debtor protection that has its maximum value when the borrower’s home equity is lower than the state homestead exemption (the debtor’s home equity is fully protected), and is decreasing in the difference between the home equity and the homestead exemption (the amount that the creditor can seize). We find that unlimited liability small businesses have lower access to credit in states with more debtor-friendly bankruptcy laws. In addition, these businesses face tighter loan terms – they are more likely to pledge business collateral, have shorter maturities, and borrow smaller amounts. For limited liability small businesses, we also find a reduction in credit availability, but of smaller magnitude, together with an increase in the loan rate.

Bank Loan Contracting and Corporate Diversification: Does Organizational Structure Matter to Lenders?

This paper investigates the effect of a firm's organizational structure on its debt financing activities. Using corporate diversification strategy as an identification tool for organizational structure, we find that diversified firms have significantly lower loan rates than comparable focused firms, and we find no evidence that diversified firms are subject to more restrictive non-price contract terms pertaining to maturity, collateral requirements, and covenant restrictions. We show that the effect of diversification on the cost of a bank loan is channeled primarily through coinsurance in investment opportunities and cash flows and that the effect is nonlinear: as the extent of corporate diversification grows, the cost-reduction benefit of diversification decreases. Our results indicate that the organizational structure of the firm can alleviate its external financing constraints and that it has an important bearing on the firm's financing capacity.

Corporate Tax Avoidance and Bank Loan Contracting

We examine the impact of corporate tax avoidance on the price and non-price terms of bank loans. We predict and provide evidence that banks charge lower loan spreads and impose fewer covenant restrictions when firms exhibit greater tax avoidance. These favorable effects are more pronounced for borrowers with higher credit risk and better governance. Firms with more effective tax avoidance are also less likely to violate covenant restrictions. Our results suggest that banks perceive tax avoidance as a credit quality improving factor and are willing to offer favorable loan contracting terms to successful tax-avoiding borrowers.

Board Quality and the Cost of Debt Capital: The Case of Bank Loans

We analyze the relation between comprehensive measures of board quality and the cost as well as the non-price terms of bank loans. We show that firms with higher quality boards and even a single (non-insider) advisory board member borrow at lower interest rates. This relation exists even after controlling for ownership structure, CEO compensation policy, and shareholder protection as well as the size and financial characteristics of the borrower and of the loan. We also show that board quality and other governance characteristics influence the likelihood that loans will have covenant requirements, but the relations differ by covenant type. Firms with high quality boards are less likely to have loans with financial ratio restrictions, but the firms are more likely to have such restrictions if they have high institutional ownership. Firms with greater diversity on the board are less likely to have collateral requirements, though these covenants are more likely when CEO cash compensation and institutional ownership are high or when the percentage of incentive-based pay or investor protection are low. Overall, the quality of the board plays an important role in lowering the cost of debt.

Does Debtor Protection Really Protect Debtors? Evidence from the Small Business Credit Market

This paper analyzes how different levels of debtor protection across U.S. states affect small firms' access to credit, as well as the price and non-price terms of their loans. We use a measure of debtor protection that has its maximum value when the borrower's home equity is lower than the state homestead exemption (the debtor's home equity is fully protected), and is decreasing in the difference between the home equity and the homestead exemption (the amount that the creditor can seize). We find that the unlimited liability small businesses (sole proprietorships and most partnerships) have lower access to credit in states with more debtor-friendly bankruptcy laws. In addition, these businesses face harsher loan terms - they are more likely to pledge business collateral, have shorter maturities, pay higher rates, and borrow smaller amounts. For limited liability small businesses (corporations and limited liability partnerships), we also find a reduction in credit availability but of smaller magnitude, together with an increase in the loan rate, and decrease in loan amounts. Our results also suggest that the personal bankruptcy law especially affects firm owners with low home equity values.

IAS/IFRS Adoption and Debt Contracting: Evidence from the UK

We investigate whether implementation of IAS/IFRS affects the debt contracting. Prior studies have focused primarily on consequences of IAS/IFRS in equity markets, whilst debt financing has not received much attention. We therefore investigate whether companies using IAS/IFRS face more or less favourable debt contracting relative to companies which do not. Analysis of extant literature indicates that answer to this question is ambiguous because of the conflicting arguments presented there. Additionally, debt contracts have multiple contract terms (interest, amount, maturity, covenants, collateral) and the effect of accounting in such setting is not well researched. We conduct a comprehensive study analysing the association between IAS/IFRS adoption and price and non-price terms of bond issues in the UK. Preliminary results offer some support that adoption of IAS/IFRS affects debt contract terms. Findings are consistent with IAS/IFRS adoption reducing the cost of debt but maturity and secured stats are not associated with accounting standards.

Accounting Quality and Debt Contracting

We study the role of borrower accounting quality in debt contracting. Specifically, we examine how accounting quality affects the borrower's choice of private versus public debt market and how the design of debt contracts vary with accounting quality in the two markets. We find that accounting quality affects the choice of the market, with poorer accounting quality borrowers preferring private debt, i.e., bank loans. This is consistent with banks possessing superior information access and processing abilities that reduce adverse selection costs for borrowers. We also find that accounting quality has an economically significant but differential impact on contract design in the two markets consistent with differences in recontracting flexibility across the two markets. In the case of private debt, since there is greater recontracting flexibility, both the price (i.e., interest) and non-price (i.e., maturity and collateral) terms are significantly more stringent for poorer accounting quality borrowers, unlike public debt where only the price terms are more stringent. The impact of accounting quality on interest spreads of public debt is 2.5 times that of the private debt, since the price terms alone reflect the variation in accounting quality.

Accounting Quality and Debt Contracting

We study the role of borrower accounting quality in debt contracting. Specifically, we examine how accounting quality affects the borrower's choice of private versus public debt market and how the design of debt contracts vary with accounting quality in the two markets. We find that accounting quality affects the choice of the market, with poorer accounting quality borrowers preferring private debt (bank loans). This is consistent with banks possessing superior information access and processing abilities which reduce adverse selection costs for borrowers. We also find that accounting quality has an economically significant but differential impact on contract design in the two markets consistent with differences in recontracting flexibility across the two markets. For private debt (which has greater recontracting flexibility), both the price (interest) and non-price (maturity and collateral) terms are significantly more stringent for poorer accounting quality borrowers, unlike public debt where only the price terms are more stringent. The impact of accounting quality on interest spreads of public debt is 2.5 times that of the private debt, since the price terms alone reflect the variation in accounting quality. Overall, the results are consistent with greater recontracting flexibility of banks enabling them to write more customized contracts relative to dispersed bondholders.

Bank risk ratings and the pricing of agricultural loans

This paper reviews the prevalence of the use of risk ratings by commercial banks that participated in the Federal Reserve’s Survey of Terms of Bank Lending to Farmers between 1997 and 2002. Adoption of risk rating procedures held about steady over the period, with a little less than half the banks on the panel either not using a risk rating system, or reporting the same rating for all their loans in the survey. However, most of these banks were small, and roughly four‐fifths of all sample loans carried an informative risk rating. After controlling for the size and performance of the bank and as many nonprice terms of the loan as possible, findings reveal that banks consistently charged higher rates of interest for the farm loans they characterized as riskier, with an average difference in rates between the most risky and least risky loans of about 1 and a half percentage points.

Bank Risk Ratings and the Pricing of Agricultural Loans

In this paper, we review the prevalence of the use of risk ratings by commercial banks that participated in the Federal Reserve's Survey of Terms of Bank Lending to Farmers between 1997 and 2002. We find that adoption of risk rating procedures held about steady over the period, with a little less than half the banks on the panel either not using a risk rating system, or reporting the same rating for all their loans in the survey. However, most of these banks were small, and roughly four-fifths of all sample loans carried an informative risk rating. We found that after controlling for the size and performance of the bank and as many nonprice terms of the loan as possible, banks consistently charged higher rates of interest for the farm loans that they characterized as riskier, with an average difference in rates between the most risky and least risky loans of about 1-1/2 percentage points.

Bank Risk Ratings and the Pricing of Agricultural Loans

In this paper, we review the prevalence of the use of risk ratings by commercial banks that participated in the Federal Reserve's Survey of Terms of Bank Lending to Farmers between 1997 and 2002. We find that adoption of risk rating procedures held about steady over the period, with a little less than half the banks on the panel either not using a risk rating system, or reporting the same rating for all their loans in the survey. However, most of these banks were small, and roughly four-fifths of all sample loans carried an informative risk rating. We found that after controlling for the size and performance of the bank and as many nonprice terms of the loan as possible, banks consistently charged higher rates of interest for the farm loans that they characterized as riskier, with an average difference in rates between the most risky and least risky loans of about 1-1/2 percentage points.

Credit Crunch during a Currency Crisis: The Malaysian Experience

I. Introduction The recent East Asian financial crisis was characterized by widespread disruption of the financial system, massive contraction of bank credit, and a sharp deceleration of economic activities. A growing body of economic literature recognizes the role of bank in macroeconomic fluctuations, where disruption in the banks' capacity to lend -- either reflecting tight monetary policy, or fragility of the intermediaries' balance sheet -- have far-reaching consequences on the spending behaviour of bank-dependent borrowers. This article evaluates the extent to which the contraction in loans and advances in the banking system during the severe recession in Malaysia, following the outbreak of the East Asian currency crisis can be attributed to the supply-side credit phenomenon. The issue is whether the sharp decline in bank lending was the result of reduced supply caused by the weak balance sheet position of financial intermediaries, which therefore heightened lenders' concerns about quality, or the result of a lack of demand by potential borrowers. The issue has important policy implications for measures to be adopted to enhance bank lending, and to increase spending by corporations and households. Recently, there have been several studies investigating the existence of a crunch in Korea, Thailand, and Indonesia during the recent financial crisis (Ghosh and Ghosh 1999; Kim 1999; Ferri and Tae 1999; Ito and da Silva 1999). The present article presents the evidence for Malaysia. The article is organized as follows: Section II analyses the different channels by which the crunch can be transmitted through the banking system, and examines the factors that influenced the supply of in Malaysia during the currency crisis. An econometric model for evaluating the magnitude of the crunch is presented in Section III, together with the empirical findings. Section IV concludes. II. Conceptual Framework and Factors Affecting the Supply of The Mechanisms of a Credit Crunch A crunch can be defined as a restriction of by financial intermediaries, to an amount that is less than the quantity that is desired by the borrowers, even if they are willing to pay for the cost of credit, and are able to satisfy the non-price terms of that are posted by the lenders. Defined in this way, a crunch represents a significant shift in the supply schedule of intermediated credit. The leftward shift in the supply curve of bank loans can be caused by the erosion in the intermediaries' capital position or deposit base, and by the portfolio reallocation decisions of the banks. For banks to extend loans, they must have the necessary funds in the form of customers' deposits, interbank borrowing, and shareholders capital. Tight monetary policy, by draining the banking system of its reserves, reduces the amount of funds banks can source from the interbank market. The reduction in the interbank funds, unless it is offset by an increase in customers' deposits, will lead to a reduction in loans. If borrowers are heavily dependent on intermediate for financing their operations, then the cutback in lending would lead to reductions in real spending. According to the credit view of the transmission of monetary policy, this channel of monetary policy operates mainly through the availability of credit, and does not rely on an increase in the interest rate to depress the demand for funds, as envisaged by the traditional money view of the transmission mechanism of monetary policy. To the extent that banks use other criteria, besides raising the lending rate, to allocate the limited amount of available among the potential borrowers, the channel can be associated with rationing of credit.(1) The channel focuses on the impact of tight monetary policy on the reduction in reserves, and the decrease in the availability of funds for making loans. …

A model for determining mispricing of sovereign risk loans

Abstract Banks are known to use non-price terms in arriving at an effective loan rate. We demonstrate that international commercial banks use similar ‘credit rationing’ terms in pricing medium-term sovereign debt. Specifically, bankers adjust the loan rate, the maturity, and grace period in order to accommodate borrowers, specific needs while maintaining a fair return for the risk of the loan. These taken together comprise an all-in effective loan rate. We present a unique model using two stage least squares, which can easily be used to determine loan mispricing. The model is demonstrated using simulated loan pricing data.

Borrower Risk and the Price and Nonprice Terms of Bank Loans

Banks are in the business of lending to risky and hard-to-value businesses. This paper show that both the price and non-price terms of bank loans reflect observable components of borrower risk. As expected, riskier borrowers - smaller borrowers, borrowers with less cash, and borrowers that are harder for outside investors to value - pay more for their loans. In addition, the non-price terms of loans are systematically related to pricing; small loans, loans that are secured, and loans with relatively short maturity carry higher interest rates than other loans, even after controlling for publicly available measures of risk. This suggests that banks use both the price and non-price terms of loans as complements in dealing with borrower risk. To validate this interpretation, I also show that observably riskier firms face tighter non-price terms in their loan contracts. Loans to small firms, firms with low ratings, and firms with little cash available to service debt, for example, are more likely to be small, to be secured by collateral, and to have a short contractual maturity. Larger and more profitable firms are able to borrow on better terms across all three of these non-price dimensions.

Relationship Lending within a Bank-Based System: Evidence from European Small Business Data

We investigate relationship lending using detailed contract information from nearly 18,000 bank loans to small Belgian firms operating within the continental European bank-based system. Specifically, we investigate the impact of different measures of relationship strength on price and nonprice terms of the loan contract. We test for the possibility of rent shifting by banks. The evidence shows two opposing effects. On the one hand, the loan rate increases with the duration of a bank–firm relationship. On the other hand, the scope of a relationship, defined as the purchase of other information-sensitive products from a bank, decreases the loan's interest rate substantially. Relationship duration and scope thus have opposite effects on loan rates, with the latter being more important. We also find that the collateral requirement is decreasing in the duration of the relationship and increasing in its scope. Journal of Economic Literature Classification Numbers: G21, G32.

Lines of Credit and Relationship Lending in Small Firm Finance

This paper examines the role of relationship lending using a data set on small firm finance. We specifically examine price and nonprice terms of commercial bank lines of credit (L/C) extended to small firms. Our focus on bank L/Cs allows us to examine a type of loan contract where the bank-borrower relationship is likely to be an important mechanism for solving asymmetric information problems associated with financing small enterprises. We find that borrowers with longer banking relationships tend to pay lower interest rates and are less likely to pledge collateral. These results are consistent with theoretical arguments that relationship lending generates valuable information about borrower quality.

Comment on Cole

The view that small firms face greater problems in obtaining credit thanlarge firms has a long history going back at least as far as the loan relationshipmodels of Hodgeman (1961) and Wood (1975) and the credit rationing work ofJa•ee and Modigliani (1969). Nevertheless, there are few studies that provideor analyze direct evidence that credit is rationed with nonprice terms to firms.At the macro level, most empirical studies of business credit availability use in-direct proxies, ranging from early studies such as Ja•ee and Modigliani (1969),who gauged availability by the share of small-sized loans among all bank loans,to more modern models that point to a role of cash flow as a determinant ofinvestment. At the micro level, empirical studies have indirectly tested forthe existence of credit rationing by assessing the behavior of loan pricing(e.g., Berger and Udell, 1992, 1995), testing whether liquidity or cash flowhas a greater impact on investment by smaller firms relative to larger firms(e.g., Fazzari et al., 1988), or investigating whether smaller firms more heavilyuse expensive trade credit during periods of tight credit (e.g., Ja•ee, 1971; Pe-tersen and Rajan, 1994).Cole (1998) fills a void in the literature on credit availability by testing howfirm characteristics a•ect a small firm’s likelihood of experiencing a loan denialusing a unique cross section data set that provides direct evidence of nonpricecredit rationing. This paper finds that preexisting financial service relationshipswith a lender have a positive e•ect on the probability of loan approvals, con-sistent with prior studies arguing that banks gain information about credit riskfrom monitoring borrower deposit activity (e.g., Black, 1975; Fama, 1985;Nakamura, 1993). In addition, results indicate that much of the e•ect of

Relationship Lending and Lines of Credit in Small Firm Finance

This article examines the role of relationship lending in small firm finance. It examines price and nonprice terms of bank lines of credit extended to small firms. The focus on bank lines of credit allows the examination of a type of loan contract in which the bank-borrower relationship is likely to be an important mechanism for solving the asymmetric information problems associated with financing small enterprises. The authors find that borrowers with longer banking relationships pay lower interest rates and are less likely to pledge collateral. These results are consistent with theoretical arguments that relationship lending generates valuable information about borrower quality. Copyright 1995 by University of Chicago Press.

Do mortgage rates vary based on household default characteristics? Evidence on rate sorting and credit rationing

Credit “screening models” suggest that lenders vary loan rates and debt ceilings across applicants on the basis of credit risk. We argue that regulatory constraints such as Fair Lending Laws may preclude rate sorting while increasing lender use of debt ceilings to adjust for applicant credit risk. Using household data from the 1983 SCF, we find that mortgage rates do not vary with applicant credit risk whereas related studies find that debt ceilings vary with borrower risk attributes. Together, these findings support arguments that regulatory constraints reduce rate sorting while increasing the use of non-price terms in the mortgage contract.