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The Design of Bank Loan Contracts, Collateral, and Renegociation

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  • Gorton, G.
  • Khan, J.

Abstract

Empirical evidence suggests that banks playa unique role in the savings-investment process, affecting firms' cost of capital and the level of investment. We argue that bank uniqueness is related to how the design of bank loan contracts allows banks to affect borrowers' choice of project risk. Unlike corporate bonds, bank loans are typically secured senior debt which contain embedded options allowing the bank to "call" the loan. The option allows the bank tv control borrowers' risk-taking activity via renegotiation of the loan. We analyze the renegotiation outcomes and show that: (1) debt forgiveness occurs; (2) monitoring by the bank is not always successful in preventing the borrower from increasing risk; (3) renegotiated interest rates are not monotonic in borrower type; (4) inefficient liquidation can occur. In renegotiation seniority and collateral are crucial because they allow the bank to threaten the borrower and liquidate inefficient projects. We show that when a prepayment option is included in the bank loan contract, bank debt is more valuable (ex ante) to borrowing firms than corporate debt; it lowers the cost of capital.

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Bibliographic Info

Paper provided by University of Rochester - Center for Economic Research (RCER) in its series RCER Working Papers with number 327.

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Length: 45 pages
Date of creation: 1992
Date of revision:
Handle: RePEc:roc:rocher:327

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Postal: University of Rochester, Center for Economic Research, Department of Economics, Harkness 231 Rochester, New York 14627 U.S.A.

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Keywords: investments ; risk ; contracts ; enterprises;

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References

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  1. Jeremy Bulow & Kenneth Rogoff, 1988. "The Buyback Boondoggle," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(2), pages 675-704.
  2. Takeo Hoshi & Anil Kashyap & David Scharfstein, 1990. "The Role of Banks in Reducing the Costs of Financial Distress in Japan," NBER Working Papers 3435, National Bureau of Economic Research, Inc.
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  4. Asquith, Paul & Gertner, Robert & Scharfstein, David, 1994. "Anatomy of Financial Distress: An Examination of Junk-Bond Issuers," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 109(3), pages 625-58, August.
  5. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," NBER Working Papers 5907, National Bureau of Economic Research, Inc.
  6. Anil Kashyap & Jeremy C. Stein, 1993. "Monetary Policy and Bank Lending," NBER Working Papers 4317, National Bureau of Economic Research, Inc.
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  16. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, American Finance Association, vol. 39(3), pages 611-25, July.
  17. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, Elsevier, vol. 7(2), pages 117-161, June.
  18. Paul R. Milgrom, 1981. "Good News and Bad News: Representation Theorems and Applications," Bell Journal of Economics, The RAND Corporation, The RAND Corporation, vol. 12(2), pages 380-391, Autumn.
  19. James, Christopher, 1987. "Some evidence on the uniqueness of bank loans," Journal of Financial Economics, Elsevier, Elsevier, vol. 19(2), pages 217-235, December.
  20. Mathias Dewatripont & Philippe Aghion & Patrick Rey, 1994. "Renegotiation design with unverifiable information," ULB Institutional Repository 2013/9591, ULB -- Universite Libre de Bruxelles.
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  22. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, American Economic Association, vol. 80(1), pages 93-106, March.
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Citations

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Cited by:
  1. Sanjay Banerji & Andrew Chen & Sumon Mazumdar, 2002. "Universal Banking Under Bilateral Information Asymmetry," Journal of Financial Services Research, Springer, Springer, vol. 22(3), pages 169-187, December.
  2. Elsas, Ralf & Krahnen, Jan Pieter, 1998. "Is relationship lending special? Evidence from credit-file data in Germany," CFS Working Paper Series, Center for Financial Studies (CFS) 1998/05, Center for Financial Studies (CFS).
  3. Birchler, Urs W, 2000. "Bankruptcy Priority for Bank Deposits: A Contract Theoretic Explanation," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 13(3), pages 813-40.
  4. Andreas Dietrich, 2012. "Explaining loan rate differentials between small and large companies: evidence from Switzerland," Small Business Economics, Springer, Springer, vol. 38(4), pages 481-494, May.
  5. Gorton, Gary & Schmid, Frank A., 2000. "Universal banking and the performance of German firms," Journal of Financial Economics, Elsevier, Elsevier, vol. 58(1-2), pages 29-80.
  6. Ingrid Groessl & Nadine Levratto, 2004. "Problems of Evaluating Small Firms’ Quality as a Reason for Unfavourable Loan Conditions," Finance, EconWPA 0406014, EconWPA.
  7. Maudos, Joaquin & Pérez, Francisco & Quesada, Javier, 2005. "Do banks discriminate sectoral real investment?," MPRA Paper 15868, University Library of Munich, Germany, revised 2005.
  8. Asea, P.K. & Blomberg, S.B., 1997. "Lending Cycles," Papers, Wellesley College - Department of Economics 97-01, Wellesley College - Department of Economics.
  9. Carlos Arriaga & Luis Miranda, 2009. "Risk and Efficiency in Credit Concession: A Case Study in Portugal," Managing Global Transitions, University of Primorska, Faculty of Management Koper, University of Primorska, Faculty of Management Koper, vol. 7(3), pages 307-326.
  10. N. Berger, Allen & F. Udell, Gregory, 1998. "The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(6-8), pages 613-673, August.
  11. Preece, Dianna & Mullineaux, Donald J., 1996. "Monitoring, loan renegotiability, and firm value: The role of lending syndicates," Journal of Banking & Finance, Elsevier, Elsevier, vol. 20(3), pages 577-593, April.
  12. Steven Ongena, 1999. "Lending Relationships, Bank Default and Economic Activity," International Journal of the Economics of Business, Taylor & Francis Journals, Taylor & Francis Journals, vol. 6(2), pages 257-280.
  13. Machauer, Achim & Weber, Martin, 1998. "Bank behavior based on internal credit ratings of borrowers," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(10-11), pages 1355-1383, October.
  14. Hind Sami, 2005. "Financial Distress and Reputational Concerns," Working Papers, Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure 0509, Groupe d'Analyse et de Théorie Economique (GATE), Centre national de la recherche scientifique (CNRS), Université Lyon 2, Ecole Normale Supérieure.
  15. Couwenberg, Oscar & de Jong, Abe, 2006. "It takes two to tango: An empirical tale of distressed firms and assisting banks," International Review of Law and Economics, Elsevier, Elsevier, vol. 26(4), pages 429-454, December.
  16. de Jong, A., 2004. "It Takes Two To Tango: an empirical tale of distressed firms and assisting banks," ERIM Report Series Research in Management, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasm ERS-2004-049-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.

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