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  Issue 1 | Archive   16 November 2009

Lending Relationships and Loan Contract Terms

A paper by Sreedhar T. Bharath, University of Michigan, Sandeep Dahiya, Georgetown University, Anthony Saunders, New York University and Anand Srinivasan, National University of Singapore

RMI's affiliated researcher A/P Anand Srinivasan, in collaboration with other co-authors, wrote the paper "Lending Relationships and Loan Contract Terms" (Review of Financial Studies, in print) to examine the impact of past relationship in lowering information asymmetries between lenders and borrowers, as well as multiple lenders.

The information asymmetry between loan borrower and lenders is costly because lenders must invest in due diligence to assess the creditworthiness of potential borrowers, to screen out unacceptably poor quality borrowers, and to monitor the borrower. When a loan is shared among multiple lenders, the lead lender (who is expected to focal in the monitoring) may put less than optimal effort in monitoring given that it does not have exposure to the entire loan. Thus, the information asymmetry among multiple lenders is costly because non-lead lenders anticipate such behavior. As a result they may increase the interest rate spread on the loan.

The authors find that the past relationship is likely to lower information asymmetry between loan lenders and borrowers, because past customer-specific information on the borrowers is costly to produce but reusable. They further contend that past relationships will also reduce the information asymmetry among multiple lenders because the relationship between lenders and borrowers lowers the cost of future monitoring, and thus can be seen as lead lender's commitment to monitor.

By examining a large set of bank loans to publicly listed corporations, the authors provide empirical evidence that repeated borrowing from the same lender have significant impact on loan spreads, collateral, maturity and loan amount. They find that recurring borrowing from the same lender translates into a 10 to 17 basis point lowering of loan spreads. This repeated interaction between same lender and borrower is at least partly reflected in the price of loans. They also find that as the information opacity of a borrower increase, the observed reduction in the cost of borrowing due to a relationship becomes greater; supporting the view that effect of past relationship in reducing loan spread is larger for firms with higher information asymmetry.

Additionally, the authors find that spreads changes for relationship loans and non-relationship loans become indistinguishable if the borrower was in the top 30% when ranked by asset size, or has a rated public debt, or is part of S&P500 index, indicating that there is a cutoff point of borrower transparency beyond which relationship loans have no apparent benefits in price for borrowers. In the case of multiple lenders, the authors find evidence that relationship lending for larger syndicates have higher spread than those for smaller syndicates. They also find that loan spread is lower for companies with a larger loan allocation to the lead bank, and also for higher loan concentrations. Although large syndicate size is a signal of non-lead lenders' concern regarding the lead lender not monitoring thoroughly; and both larger loan allocation to the lead bank and higher loan concentration are indications of higher non-lead lenders' concerns, the results support the view that past relationships can mitigate non-lead lenders' concerns of lead lenders monitoring effort. In addition, the authors provide non-price empirical evidence that relationship loans require less collateral and increases the amount of loan obtained by borrowers. This provides, further support for the assertion that past relationship reduces information asymmetry between lenders and borrowers, providing borrowers with the opportunity to borrow more and put up less collaterals.

The authors also document that for both high-quality and low-quality firms, relationship loans are of shorter maturity. They find that for high quality borrowers, shorter maturity makes borrowing costs more sensitive to future information, thus they will choose short term loans, expecting future news to be favorable; while low quality borrowers requiring intense monitoring and would be supplied with only short-term loans.

In conclusion, this paper provides empirical evidence that for publicly traded firms, there are significant benefits of borrowing for lenders with past relationships with banks.

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Editor: Ivy Wang (rmiwy@nus.edu.sg)