Stochastic Growth Prospects and Corporate Demand for Lines of Credit

The loan commitment or credit line is today the most pervasive arrangement in bank commercial lending. Due to their increased prevalence, credit lines have come under increased regulatory scrutiny, especially as risk-based capital requirements have been imposed on banks in recent years. Two main theoretical views explain the role credit lines play in the loan market. In the first, credit lines serve as options which corporations can employ to hedge against credit worthiness deterioration or credit rationing. In the second view, credit lines emerge as optimal solutions to asymmetric information problems in non-cooperative games between corporate borrowers and bank lenders. Neither of these approaches incorporates the attributes which Federal Reserve surveys have reported as the paramount reason firms demand credit lines flexibility and speed of action in the pursuit of investment opportunities. The authors' model accommodates the flexibility and speed motivations for credit lines by modeling the credit line choice behavior of a risk neutral firm under perfect competition. They examine a risk neutral firm's use of this type of contract within a continuous-time, stochastic framework, where profit opportunities arrive randomly. Firms obtain credit lines because they need the ability to move quickly and confidentially in order to take advantage of stochastic, transient investment opportunities which arrive on a continual basis. This type of environment allows the firm the flexibility to use credit lines to meet short-term working capital needs as well as to fund more traditional capital investment projects. The authors provide a background and review existing models in the literature. The authors model credit line demand using a new framework in which the firm's credit line demand is determined by uncertainty in the future need for cash owing to stochastic arrival of investment opportunities. The firm assesses its growth prospects and the pricing structure of the available credit line contract; it then chooses a credit line that equalizes commitment cost of a credit line today against the differential cost of expected spot borrowing tomorrow if the credit line is overrun. As expected, credit line size is decreasing in the commitment cost and increasing in the cost incurred due to overruns. With this framework, the authors account for differences in cross-industry demand for and usage patterns of lines of credit because there is a direct relationship between a firm's growth prospects and its demand for credit lines. The more growth a firm expects in its future needs for cash, the greater the credit line it demands. Other things equal, high growth industries will have more credit line demand and usage than low growth industries. When volatility around a given growth rate increases, firms demand lower credit lines. The decrease in demand occurs because the marginal benefit of the credit line in avoided spot borrowing is more than offset by the increase in the option premium represented by the line commitment fee. As a result, the model suggests that low volatility industries will have more credit line demand and usage than will high volatility industries.