Jointness of loan contract terms, information asymmetries, and lending relationships

This thesis shows that five key loan contract terms – price, collateral, maturity, covenants, and size – are jointly determined and investigates how lenders and borrowers trade these off to address information asymmetries. It further examines whether prior lending relationships affect loan covenants and size and whether borrowers with higher information asymmetries obtain better loan terms from their relationship lenders. Since revolving and term loans differ in their characteristics, these issues are examined for the two loan types separately. The sample consists of 17,636 revolving and 6,625 term loans made by banks operating in the United States to U.S. non-financial firms from 1 January 1994 to 31 December 2009. A system of five simultaneous equations is used to examine loan term jointness. It also provides coefficients for an information asymmetry proxy and a lending relationship measure to examine how loan terms are used to address information asymmetries as well as whether prior lending relationships impact loan covenants and size. This model is modified by adding a product of the information asymmetry and lending relationship measures and then used to investigate if borrowers with higher information asymmetries obtain better terms from their relationship lenders. The empirical results show all five key loan terms are jointly determined. For revolving loans, high information asymmetry borrowers pay higher prices, are more likely to be required to provide collateral, and accept shorter maturities in return for obtaining larger loans with fewer covenants. For term loans, such borrowers pay higher prices and are more likely to pledge collateral in return for larger loans. Those borrowers with prior lending relationships accept more covenants but obtain larger loans for both two loan types. Borrowers with higher information asymmetries, however, obtain neither lower prices nor more favourable non-price terms from their relationship lenders. This thesis makes several academic contributions. It extends other studies (e.g., Dennis, Nandy, and Sharpe, 2000) to include covenants and loan size as key loan contract terms and finds that all five loan terms are jointly determined. Moreover, this study is the first to provide evidence that borrowers and lenders trade off loan terms when addressing borrower information asymmetries. It is also the first to show that borrowers accept more covenants but obtain larger amounts from their relationship lenders. It augments the work of Bharath, Dahiya, Saunders, and Srinivasan (2011) by examining both price and non-price terms in a simultaneous equation model across revolving and term loans but finds no evidence that borrowers with higher information asymmetries obtain better loan terms from their relationship lenders. Regarding methodology, this work extends prior studies by using a system of simultaneous equations to mitigate potential simultaneity problems, considering differences between revolving and term loans and obtaining different findings across these loan types. This study reveals the endogeneity of loan selection and addresses the problem by using the borrower GVKEY and lender RSSD ID in the sampling selection to trace back prior lending relationships, thus improving the accuracy of the results. These findings should prove of interest to academics, lenders, borrowers, and policymakers. Academics should consider the jointness of all key loan terms to address their endogeneity issues. Revolving and term loans should not be pooled together in a single sample and the endogeneity of loan type selection (i.e., revolving and term loans) should be also addressed. Lenders should seek to trade off different loan terms and address asymmetric information problems to satisfy their borrowers but be aware that this trade-off differs, depending on loan type. Lenders can also use more loan covenants and make larger loans to their relationship borrowers due to the information obtained from their lending relationships. Borrowers with prior lending relationships have the advantage of be able to obtain larger loans from their relationship lenders but these loans can entail more covenants. Rather than just accept less favourable terms, as suggested by prior studies, borrowers with high information asymmetries may trade them for better ones; however, even lending relationships will not allow them to obtain better loan terms, except for larger term loans, from their relationship lenders. Borrowers should also be aware that lenders can set loan terms differently across revolving and term loans. Policymakers should avoid risk management regulations focusing only on individual specific terms and instead encourage banks to consider all loan contract terms.