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Do banks price their informational monopoly?

  • Galina Hale
  • Joao A. C. Santos

Modern corporate finance theory argues that although bank monitoring is beneficial to borrowers, it also allows banks to use the private information they gain through monitoring to "hold-up" borrowers for higher interest rates. In this paper, we seek empirical evidence for this information hold-up cost. Since new information about a firm's credit-worthiness is revealed at the time of its first issue in the public bond market, it follows that after firms undertake their bond IPO, banks with an exploitable information advantage will be forced to adjust their loan interest rates downwards, particularly for firms that are revealed to be safe. Our findings show that firms are able to borrow from banks at lower interest rates after they issue for the first time in the public bond market and that the magnitude of these savings is larger for safer firms. We further find that among safe firms, those that get their first credit rating at the time of their bond IPO benefit from larger interest rate savings than those that already had a credit rating when they entered the bond market. Since more information is revealed at the time of the bond IPO on the former firms and since this information will increase competition from uninformed banks, these findings provide support for the hypothesis that banks price their informational monopoly. Finally, we find that while entering the public bond market may reduce these informational rents, it is costly to firms because they have to pay higher underwriting costs on their IPO bonds. Moreover, IPO bonds are subject to more underpricing than subsequent bonds when they first trade in the secondary bond market.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-14.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-14
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