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.
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