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The Loan Commitment as an Optimal Financing Contract

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  • Berkovitch, Elazar
  • Greenbaum, Stuart I.

Abstract

This paper provides an imperfect information explanation for the existence of bank loan commitments when both the bank and the potential borrower are risk neutral. The borrower is assumed to have access to a two-stage investment project wherein the investment required in the second stage is not known at the outset. The unknown investment requirement is revealed to the borrower, but not to the bank, at the beginning of the second stage. If the investor borrows at the beginning of the first stage, the realization at the beginning of the second stage might prompt a default in a situation where the project yields positive net present value. The reason is that the borrower does not regard the first-stage investment as a sunk cost. We show that a two-stage contract resembling a loan commitment can solve this under-investment problem.

Suggested Citation

  • Berkovitch, Elazar & Greenbaum, Stuart I., 1991. "The Loan Commitment as an Optimal Financing Contract," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(1), pages 83-95, March.
    • Handle: RePEc:cup:jfinqa:v:26:y:1991:i:01:p:83-95_00
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    Cited by:

    1. Zivney, Terry L. & Luft, Carl F., 1999. "Hedging individual mortgage risk," Financial Services Review, Elsevier, vol. 8(2), pages 101-115.
    2. Heitor Almeida & Murillo Campello & Igor Cunha & Michael S. Weisbach, 2014. "Corporate Liquidity Management: A Conceptual Framework and Survey," Annual Review of Financial Economics, Annual Reviews, vol. 6(1), pages 135-162, December.
    3. 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, vol. 22(6-8), pages 613-673, August.
    4. Allen N. Berger & Marco A. Espinosa‐Vega & W. Scott Frame & Nathan H. Miller, 2005. "Debt Maturity, Risk, and Asymmetric Information," Journal of Finance, American Finance Association, vol. 60(6), pages 2895-2923, December.
    5. Houston, Joel F. & Venkataraman, S., 1996. "Liquidation under moral hazard: Optimal debt maturity and loan commitments," Journal of Banking & Finance, Elsevier, vol. 20(1), pages 115-133, January.
    6. May, Anthony D., 2014. "Corporate liquidity and the contingent nature of bank credit lines: Evidence on the costs and consequences of bank default," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 410-429.
    7. Jine Qian & Qiang Gong & Leonard F.S. Wang, 2021. "Corporate social responsibility, loan commitment, and social welfare in network duopoly," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 42(4), pages 952-960, June.
    8. O. Emre Ergungor, 2001. "Theories of loan commitments: a literature review," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 2-19.
    9. Martin, J. Spencer & Santomero, Anthony M., 1997. "Investment opportunities and corporate demand for lines of credit," Journal of Banking & Finance, Elsevier, vol. 21(10), pages 1331-1350, October.
    10. Plaut, Steven E. & Melnik, Arie L., 2003. "International institutional lending arrangements to sovereign borrowers," Journal of International Money and Finance, Elsevier, vol. 22(4), pages 459-481, August.
    11. Rauf, Asad, 2023. "Bank stability and the price of loan commitments," Journal of Financial Intermediation, Elsevier, vol. 54(C).
    12. Qianwei Ying & Danglun Luo & Lifan Wu, 2013. "Bank Credit Lines and Overinvestment: Evidence from China," The International Journal of Business and Finance Research, The Institute for Business and Finance Research, vol. 7(2), pages 43-52.
    13. Bouwman, Christa H. S., 2013. "Liquidity: How Banks Create It and How It Should Be Regulated," Working Papers 13-32, University of Pennsylvania, Wharton School, Weiss Center.
    14. Sumit Agarwal & Souphala Chomsisengphet & John C. Driscoll, 2004. "Loan commitments and private firms," Finance and Economics Discussion Series 2004-27, Board of Governors of the Federal Reserve System (U.S.).
    15. Stanhouse, Bryan & Schwarzkopf, Al & Ingram, Matt, 2011. "A computational approach to pricing a bank credit line," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1341-1351, June.
    16. Luísa Farinha & Sónia Félix & João A. C. Santos, 2019. "Bank Funding and the Survival of Start-ups," Working Papers w201919, Banco de Portugal, Economics and Research Department.

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