Book-tax differences, CEO overconfidence, and bank loan contracting

We assess information embedded in the difference between the reported book income and the taxable income (the book-tax difference, BTD hereafter) from the debtholders’ point of view. Using bank loan contracts of the U.S. publicly traded companies over years 2001–2017, we find that firms with larger book-tax differences pay higher interest for bank loans than do firms with smaller book-tax differences. Moreover, we find that banks reduce the use of financial covenants while increasing the use of general covenants for borrowers that have larger book-tax differences. In addition, banks are more likely to shorten loan maturity and require their loans to be collateralized for borrowers with larger book-tax differences. Furthermore, we find that the effects of BTDs on loan contracting are stronger if the CEOs of the borrowers are overconfident. Taken together, our findings suggest that larger book-tax differences increase a bank’s concerns regarding a borrower’s information risk and default risk. Thus, banks tend to take price and non-price protection against borrowers which have large BTDs.