NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Design of Bank Loan Contracts, Collateral, and Renegotiation

Gary Gorton, James A. Kahn

NBER Working Paper No. 4273
Issued in February 1993
NBER Program(s):   CF

Empirical evidence suggests that banks playa unique role in the savings-investment process, affecting firms' cost of capital and the level of investment. We argue that bank uniqueness is related to how the design of bank loan contracts allows banks to affect borrowers' choice of project risk. Unlike corporate bonds, bank loans are typically secured senior debt which contain embedded options allowing the bank to "call" the loan. The option allows the bank tv control borrowers' risk-taking activity via renegotiation of the loan. We analyze the renegotiation outcomes and show that: (1) debt forgiveness occurs; (2) monitoring by the bank is not always successful in preventing the borrower from increasing risk; (3) renegotiated interest rates are not monotonic in borrower type; (4) inefficient liquidation can occur. In renegotiation seniority and collateral are crucial because they allow the bank to threaten the borrower and liquidate inefficient projects. We show that when a prepayment option is included in the bank loan contract, bank debt is more valuable (ex ante) to borrowing firms than corporate debt; it lowers the cost of capital.

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Document Object Identifier (DOI): 10.3386/w4273

Published: Gorton, G. and J. Kahn. "The Design Of Bank Loan Contracts," Review of Financial Studies, 2000, v13(2,Summer), 331-364.

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