TY  - JOUR
AU  - Gorton,Gary
AU  - Kahn,James A.
TI  - The Design of Bank Loan Contracts, Collateral, and Renegotiation
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 4273
PY  - 1993
Y2  - February 1993
UR  - http://www.nber.org/papers/w4273
L1  - http://www.nber.org/papers/w4273.pdf
N1  - Author contact info:
Gary B. Gorton
Yale School of Management
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
Fax: 203/432-8931
E-Mail: Gary.Gorton@yale.edu

James Kahn
Economics Department
Yeshiva University
Belfer Hall, 5th Floor
500 W. 185th St
New York, NY 10033
Tel: 212-960-5400 x6964
Fax: 212-960-0846
E-Mail: jkahn1@yu.edu
AB  - 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.
ER  -