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Agency Costs, Bank Specialness and Renegotiation

Sreedhar T. Bharath New York University

This Draft - January, 2002 First Draft - April, 2001 Job Market Paper - Comments Welcome Please do not quote or distribute

I am indebted to my advisors Yakov Amihud and Anthony Saunders for constant advice and encouragement. I wish to thank my other committee members Kose John, Anthony Lynch and Rangarajan Sundaram and seminar participants at Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, New York University for helpful comments and suggestions that have greatly improved the paper. I also thank Viral Acharya, Linda Allen, Jennifer Conrad, Florian Heider, Eli Ofek, Matthew Richardson and David Yermack for their comments. All errors are my responsibility. Contact: Sreedhar T. Bharath, Department of Finance, Stern School of Business, New York University, 44 West 4th St., Suite 9-153, NY, NY 10012. Tel: 2129980376 Fax: 2129954233 email: sbharath@stern.nyu.edu

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Agency Costs, Bank Specialness and Renegotiation

Abstract This paper proposes the yield spread between public bonds and bank loans of the same rm (the Bond-Bank spread) as a measure of compensation for agency costs that cannot be mitigated by bondholders but can be mitigated by banks due to their ability to monitor the rm and renegotiate the loan. In a model of debt pricing and choice, the tradeo between rm moral hazard and bank opportunism, leads to co existence of relationship debt (bank loans) and uninformed debt (bonds) in its capital structure. Contrary to common concerns, bank oversight actually increases in the presence of bonds. Using a large and unique data set of bond and bank yields, for the same rm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral dierences, it is shown that the Bond - Bank Spread is negative for high credit quality rms and positive for low credit quality rms, consistent with the theoretical model. Applying a new econometric methodology on matching developed by Heckman et al(1998), the results of the sample are conrmed. The Bond - Bank Spread is about -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or the specialness of banks seem to be important for BBB and below investment grade rms across the credit spectrum.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Contents
1 Introduction 1.1 Main Results: A Synopsis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 7 10 14

2 Literature Review 3 The Model 3.1 3.2 3.3

The Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Lenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Information and Contracting Environment . . . . . . . . . . . . . . . . . . . . . . . . 15 16

4 Firms Choice of Financing 4.1 4.2

Borrowing from the Bond Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Borrowing from Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 4.2.1 Denition of Equilibrium at t = 1 and specication of cases . . . . . . . . . . 18

4.3 4.4 4.5

Borrowing from both Banks and Bond markets . . . . . . . . . . . . . . . . . . . . . 26 Endogenizing Bargaining Power k . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

Borrowing from Multiple Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 34 34

5 Empirical implications 6 Sample Selection and Data 6.1

Computation of Bond Bank Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 36

7 Methodology and Empirical Results 7.1

Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 7.1.1 Alternative Matching Estimators . . . . . . . . . . . . . . . . . . . . . . . . . 38 . . . . . . . . 39

7.2 7.3 7.4

Adjustment for Collateral Dierences between Bank Loans and Bonds Mean and Median Spread Dierences, Collateral Adjustment

. . . . . . . . . . . . . 40

Possibility of mispricing by banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 42

8 Conclusion

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 9 Appendix 44

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Introduction

What is the magnitude of agency costs between stockholders and debtholders? What is the worth of a banking relationship to a rm? How important is the ability to renegotiate contracts between parties as information evolves and contingencies arise in the future? The main purpose of this paper is to build a tractable model of rms debt nancing choice and its pricing to answer these questions and then empirically assess the magnitude using market determined yields of debt securities. The model attempts to knit together in one tractable framework, specic elements of 3 distinct literatures namely, (1) Agency Costs of Debt (2) Monitoring by Banks and (3) Renegotiation between the rm and the bank, as more information is revealed in the relationship. The empirical work constructs a unique and large data set of over 15,000 observations of market yields by carefully matching bank loans and bonds of the same rm on multiple dimensions to oer empirical evidence on the magnitude of agency costs, the value of bank specialness and the importance of renegotiation. The empirical work also conrms the results by employing a new econometric methodology on matching developed by Heckman et al(1998). Debt nancing by a corporation gives rise to conicts of interest between creditors and stockholders that can reduce the value of the rm. Such conicts are limited more eectively in private loans extended by banks and other institutions than in publicly traded bonds. However, nance literature is largely silent on the magnitude of this eect.1 Due to the limited evidence available on the magnitude of agency costs of debt, no consensus has been reached on their overall importance2 . Much of the recent literature in corporate nance discusses agency issues in dierent settings. The importance of these ideas nally rely on the magnitude of the shareholder-debtholder conict. Financial intermediation literature (both theoretical and empirical) beginning with Diamond (1984) and Ramakrishnan and Thakor (1984) has emphasized the specialness of banks which arise as delegated monitors in order to solve information gathering problems. This view suggests that banks have a comparative advantage in preventing opportunistic behavior by borrowers during the realization of the project and punishing a borrower who fails to meet contractual obligations. However, the empirical evidence on the benets of banking relationships is less direct and concerns positive and negative stock price reactions of the borrower to loan renewals and loan sales respectively. It is desirable to provide direct evidence on the specialness of banks.3 Gilson and Warner (1999), however nd that rms that want to maintain their ability to grow rapidly, replace bank loans by junk bonds. A third strand of literature is the nancial contracting literature that takes its starting point
Early discussions of these concepts include Fama and Miller (1972), Jensen and Meckling (1976) and Myers (1977) The available evidence is also indirect, and relies on numerical simulations. Chief papers in this vein are Parrino and Weisbach (1999) and Titman, Tompaidis and Tsyplakov (1999) 3 See James (1987),Lummer and McConnell (1989) and Dahiya, Puri and Saunders(2001)
2 1

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 the idea that a relationship between a rm and its investors is dynamic rather than static. As the relationship develops over time, eventualities arise that could not easily have been foreseen or planned for in an initial contract between the parties. Beginning with Aghion and Bolton (1992), the literature has focused on the allocation of control rights, cash ow rights and private benets once the relationship is underway.4 In such an incomplete contracting environment, the ability to renegotiate leads to more ecient outcomes in some states of the world. However the value of renegotiation, which is central to many of the papers in this literature is a matter of conjecture. The setting that is used to study the issues of Agency costs of debt, Specialness of banks and Renegotiation, is corporate debt in rm capital structures, of which public bonds and bank loans are an important component. As can be seen from Figure 1 (top panel) , Corporate New Issues in the US totalled 2.157 trillion dollars in 1997. Bank loans and Bonds accounted for 77% or 1.661 trillion dollars of the total issuance. In contrast, equity issuance was at 0.194 trillion dollars (9% of total), thus about an order of magnitude smaller. Figure 1 (bottom panel) provides evidence on the composition of the capital stock of equity (in market value terms), bonds and bank loans of US corporations in the 1990s. Even accounting for the high equity values in the decade, it can be seen that as of 1999, equity and debt accounted for 48% and 52% of the total capital stock of US corporations compared to a share of 27% and 73% respectively in 1990. Thus in terms of capital stock, debt markets are comparable to equity markets, while in terms of ow they are an order of magnitude bigger. This paper attempts to develop a theory and provide evidence on the magnitude of the issues discussed above, in this economically important setting. The main object of interest in this paper is the yield spread between public bonds and bank loans of the same rm (also referred to as the Bond-Bank spread in the paper). A bank can write tighter and tailor made covenants for its loan. By being able to monitor the rm, it can also act to enforce these covenants and ensure its welfare, whenever there is a conict of interest. It can also use the new information uncovered in monitoring to conduct renegotiation of the loan contracts with the rm. On the other hand, bond holders are diuse and suer from a coordination problem to monitor the rm and safeguard their interests. Thus one important adjustment that should be taken into account is the compensation that is asked by the bond holders. As they can later be victimized by the rm, they insist on a yield that is high enough to outweigh this danger. Thus the yield spread between public bonds and bank loans of the same rm (after explicitly controlling for the dimensions on which Bank Loan and Bond contracts dier) should be a direct measure of the agency costs of debt of the rm. Alternatively, it can be interpreted as a measure of bank specialness where the bank performs the role of a delegated monitor. A third interpretation of the spread, is that, it is premium paid by the bank for the option to renegotiate. In order to get theoretical guidance on the yield spread between public bonds and bank loans, this paper attempts to knit together in one tractable framework, specic elements of the aforesaid
4

Related papers include Diamond (1991), Hart and Moore (1988)

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 literatures namely, (1) Agency Costs of Debt (2) Monitoring by Banks and (3) Renegotiation between the rm and the bank, as more information is revealed in the relationship. While one or simultaneous interplay of two of these issues, has been studied in the literature, the model in this paper attempts to unify all the three elements in one setting. The paper proceeds by constructing a model of bank loans (private debt) and public bonds (public debt) in rm capital structures. Co-existence of bank loans and bonds in equilibrium enables the computation of promised yields on bank loans and bonds and hence the Bond-Bank spread. In order to empirically assess the magnitude of Agency Costs or Bank Specialness or the value of renegotiation, it is necessary to match the public bonds and bank loans of the same rm at the same point in time and obtain their market determined yields. The matching problem is compounded by the fact that bank loans and bonds are contractually very dierent on multiple dimensions such as seniority, maturity, and collateral. Further bond spreads are measured relative to treasury rates whereas loan spreads are relative to LIBOR, and the two must be put on a common basis before the Bond-Bank spread can be computed. This paper undertakes the task of constructing such a unique and large data set of over 15,000 observations of market yields by carefully matching bank loans and bonds of the same rm on multiple dimensions to oer empirical evidence on the magnitude of agency costs, the value of bank specialness and the importance of renegotiation. To ensure that the results obtained are not driven by the matching procedure used, the paper also employs a new econometric methodology developed by Heckman et al(1998), that views matching of Bonds and Bank loans as an econometric evaluation estimator. Using seven dierent matching methods, the results of the matched sample are then conrmed by this methodology. Alternative explanations for the spread such as mispricing by banks are also considered, but do not nd support. Subsection 1.1 outlines the main theoretical and empirical results of the paper.

1.1

Main Results: A Synopsis

This paper proposes a model of debt pricing and choice with rm moral hazard and bank holdup. It emphasizes that a rms desire for nancial exibility leads to co existence of relationship debt (bank loans) and uninformed debt (bonds) in its capital structure. Banks are useful because they are able to monitor and check value reducing, risky, asset substitution activities of the rm. Bonds alone are unable to perform this function and thus not contractible. However, by virtue of information gained during the course of the lending relationship, banks behave opportunistically and hold up the rm ex-post, to extract rents after projects are in place in return to providing continuation nancing. Uninformed lenders such as the bond markets can then be used by the rm in conjunction with bank loans. Bonds are now contractible, free riding on the monitoring performed by banks. The presence of bonds serves to limit the rent extraction aspect of bank

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 nancing , while the rm continues to enjoy the relationship benets of bank nancing. Optimal trade o of the benets and costs of bank nancing results in coexistence of bank loans and bonds. The paper provides detailed analytical characterization of the bank lending patterns for dierent types of rms (proxied by the degree of bargaining power of the rm vis-a-vis the bank) highlighting the costs and benets of bank nancing. It also explicitly derives closed form solutions for the case of coexistence of banks and bonds. The model endogenizes the banks decision to engage in costly and imperfect monitoring unlike the extant literature where monitoring is costless, perfect and exogenous, while explicitly considering the benets and costs of banks and incorporating the role of public bonds. 5 Contrary to common concerns, the paper nds that bank oversight (monitoring) increases in the presence of bonds. As bond markets develop in an economy, there is some concern expressed that it reduces bank monitoring eorts and oversight thereby increasing value dissipating activities of the rm. This model shows however that such concerns are misplaced. The presence of uninformed bond holders increases the risk shifting incentives of the rm compared to a rm that has been fully nanced by the bank. This incentivizes the bank to monitor more intensely as the bank is able to detect and liquidate value reducing projects (generated by the risk shifting activities of the rm) only by the process of monitoring. The osetting eect is the reduced ability of the bank to hold up the rm and extract rents due to the presence of bonds in the capital structure. However the rm chooses the optimal amount of bank debt to obtain ecient continuation benets and yet circumscribe the power of the bank to hold it up. It is also shown that multiple banking relationships are not as eective as bond markets in satisfying the rms need for nancial exibility and as a possible solution to the hold up problem. The reason is that, while monitoring enhances the chances of hold up, symmetrically informed banks have the incentive to compete in order to improve their payos individually, rather than collectively hold up the rm. While this reduces the extent of the hold up, the problem still persists when the banks are asymmetrically informed. The informed bank continues to hold up in that case. The object of testable empirical interest from the model is the Bond-Bank spread. The spread is computed for two cases : (i) Bank loans senior to bonds and (ii) Banks and Bonds have equal seniority. In the case when bank loans are senior to bonds, the Bond-Bank spread is shown to be positive despite osetting costs of bank nance, namely costly monitoring.6 The benet of seniority to the bank is sucient to overcome the monitoring costs, thus enabling the bank to seek a lower promised
Park(2000) and Rajan and Winton (1995) are notable exceptions. However they are concerned with showing how features of bank contracts emerge endogenously and are not concerned with bonds. This paper builds on their results and assumes bank contracts as given and incorporates bonds in the analysis 6 In the absence of osetting costs, it is trivial to note that seniority of bank loans with respect to bonds implies a positive Bond-Bank spread
5

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 yield. However as a practical matter, seniority of bank loans implies higher recovery rates at the time of default and advantages in the reorganization process during bankruptcy, which could aect the Bond-Bank spread in ways other than what is identied in this paper. Thus the Bond-Bank spread is also computed theoretically for the case when both types of debt are equally senior. With equal seniority, the paper shows that for High Quality Firms, above a certain threshold (proxied for in the model by how often the good project outcome is likely to be realized), the BondBank spread is negative. The only dierence between bank loans and bonds with equal seniority is the expected hold up benets enjoyed by the bank and the monitoring costs incurred by it. Monitoring costs increase the yield on bank loans while an increase in ex-post hold up benets for the bank serves to decrease the ex-ante yield. For a bank lending to a high quality rm, monitoring costs outweigh the ex-post hold up benets thus causing the bond-bank spread to turn negative. For rms below this threshold or Low Quality Firms, the opposite is true, causing the spread to be positive. For certain parameter restrictions of the model, ex-post hold up benets enjoyed by the bank always dominates the monitoring costs, thus causing the Bond-Bank spread to remain positive for all rms. These are the implications that are tested empirically, with credit rating used as the proxy for rm quality. The empirical study uses matching which is a widely-used method of evaluation. The methodology is similar to that used in medicine and statistics. It is based on the intuitively attractive idea of contrasting the outcomes (yields) for a bank loan to that of a bond. Dierences in the yields can then be attributed to the ability of banks to monitor and renegotiate and thus mitigate agency costs. Sample selection criteria is thus used as a principal method for achieving comparability and appropriateness. In order to substantially reduce bias in non experimental estimates, the literature on matching suggests that (1) Controls and participants have the same distribution of observed personal characteristics (2) Outcomes and characteristics are measured in the same way for both groups and (3) Participants and controls are placed in the same economic environment. In the application considered, Bonds can be thought of as the participants and Bank Loans as the control group. In the current case conditions (2) and (3) are met rather well, as market determined yields for both bank loans and bonds are compared at the same point in time. Further the matching method attempts matches on personal characteristics (Seniority,maturity, credit ratings and collateral in this case) as closely as possible between loans and bonds in order to meet condition (1). Thus the method of collecting the sample and matching each loan and bond can produce a simple estimate of the yield dierence between bonds and bank loans which is the focus of this paper. The paper uses a large and unique, carefully constructed data set from multiple data sources of Bond and Bank yields for the same rm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral dierences. It is then shown that the Bond Bank

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Spread is negative for high credit quality rms and positive for low credit quality rms, consistent with the theoretical model. Applying a new econometric methodology developed by Heckman et al(1998), that views matching of Bonds and Bank loans as an econometric evaluation estimator, the results of the sample are conrmed rigorously. The Bond - Bank Spread is about -6 basis points for AAA,AA rated borrowers, -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or value addition by banks seem to be important for BBB and below investment grade rms across the credit spectrum. The paper is organized as follows. Section 2 provides a literature review. Section 3 describes the model set-up. Section 4 characterizes the rms choice of nancing. Section 5 considers the empirical implications of the model. Section 6 describes the data and sample selection. Section 7 describes the methodology for empirical analysis and describes the results. Section 8 concludes. Proofs of theoretical results are relegated to the Appendix.

Literature Review

A number of factors have been advanced to explain the advantages of relationship debt held by a bank relative to uninformed debt held by bond holders. However, rms that might nd these advantages from a bank, not relevant to their activities look towards nancing from alternative sources such as bonds. Most of the existing work, that has focused on this choice faced by rms between bank loans and bonds, generates rationales based on the characteristics of rms, that nd it worthwhile to go to banks and markets. They deliver the implication that certain types of rms borrow exclusively from banks and certain others from markets. Models that study the choice of debt in this vein include Diamond (1991,1993), Bolton and Friexas (2000), Chemmanur and Fulghieri (1994), Repullo and Suarez (1998), Hoshi, Kashyap, and Scharfstein (1993), and, Boot and Thakor (1997a) among others. These models generate the simultaneous existence of both bank loans and bonds at the economy wide level in equilibrium and are concerned with explaining inter temporal change in demand for these types of nancing, security design, and the architecture of the nancial system. Crucially, an individual rm in these models holds either bank debt or bonds only, at a point in time. A casual look at capital structure data at the rm level suggests that the very big rms such as GE borrow almost exclusively from the bond markets. The very small rms which are covered by the National Business Survey of Small Firms , are too small to access the bond markets and have bank borrowing as the main source of debt. However for the vast majority of rms in between, both bank loans and bonds are the source of nancing. Indeed, in a random sample of 250 rms taken from COMPUSTAT, Houston and James (1996) nd that the average rm has 63 percent of its

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 debt as bank debt and 16 percent as bonds with systematic cross sectional variation across rms. The model in this paper proposes an explanation for this coexistence of bank loans and bonds in rm capital structures. This paper is related to the literature which considers the co existence of bank loans and bonds at the rm level. Chief papers that examine this issue include Green and Juster (1995), Holmstrom and Tirole (1997), Carey and Rosen (2001) and Besanko and Kanatas (1993). In Green and Juster, rms choice of debt is intended as a signal of their quality based on their expectation of renegotiation in nancial distress. In contrast no signalling equilibrium is possible in the model presented in this paper. Holmstrom and Tirole concern themselves with a model of nancial intermediation where rms and intermediaries are capital constrained and seek to explain lending patterns observed during nancial crises. This paper assumes no nancial constraints and follows the traditional literature. Carey and Rosen (2001) present a model of bank loans and bonds based on incomplete contracting but no asymmetric information where public debt acts as a punching bag for ex post renegotiations between the rm and the bank. This paper concerns itself with renegotiation of incomplete contacts under asymmetric information. More importantly, this paper assumes that monitoring by banks is costly, imperfect and endogenous driven by its own incentives in contrast with the traditional assumption of costless, perfect and exogenous monitoring employed in all these papers. Besanko and Kanatas consider the moral hazard of the bank in not being able to contractually commit to its monitoring activities and this limits the usage of bank debt. This paper follows the view of Diamond (1984) of banks as delegated monitors and assumes that gains from monitoring exceed its costs and abstract from such considerations. Further while they demonstrate coexistence, they do not explicitly solve for the mix of two types of debt and their prices in the model. Seward (1990) is the rst paper that demonstrates the complementarity between capital markets and nancial institutions by examining the optimal structure of nancial contracts in an economy subject to moral hazard. This paper builds on these results by assuming the contracts as given and study the optimal mix and prices of the two types of debt at the rm level. There is a growing literature on the design of appropriate bank loan contracts to enhance eciency taking into account the special nature of nancial intermediation and its attendant costs. Gorton and Kahn (2000), Park (2000), Rajan and Winton (1995) study this problem in detail and demonstrate how unique contract features of bank loans emerge endogenously. The latter two papers explicitly consider endogenous monitoring incentives. This paper appeals to their results and takes the contract features of bank loans as given and adds bonds to the analysis and sets out to derive the optimal share of each in the rm capital structure. Further it also computes the prices of bank loans and bonds and thus the Bond-Bank spread. The model structure employed in this paper follows Park (2000) but adds bonds, the hold up problem leading to bargaining between the

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 bank and rm, multiple banking relationships and debt pricing to the analysis. Since nancial transactions involve time in an essential way, any nancial transaction would establish a relationship between the two parties. However, borrowing from a bank is a one-to-one and more likely a long term relationship compared to that of bonds which are held by diuse investors. Further it is likely to be more dicult to renegotiate terms of bond contracts to improve ex-post eciency, due to transaction costs and the free rider problem where each investor holds out hoping the other investors make necessary concessions. Financial intermediation theory following Diamond (1984) suggests that banks act as delegated monitors reducing information and incentive problems. It is more ecient for a nancial intermediary such as a bank than it is for numerous investors to monitor the rms activities, to take corrective action, and reorganize the rm if it follows too risky a strategy. The presence of bond holders as nanciers does not aord such a exibility of renegotiation. Thus relationships with banks are valuable compared to transactions from arms length market for rms. However rms which do not need the services of banks move on to the capital market to raise capital in the form of bonds to obtain cheaper nancing. Existing literature on capital structure of bonds vs. bank loans has focused on this behavior of rms economy wide. At the same time, relationships involve commitment and specic investments by both parties. Information is generated during the course of a relationship. Over time a bank may acquire a large amount of information about a rm to which it supplies funds, both because it has investigated the rm before it lent the money and because it obtains information while providing nance. This information is not available to other lenders either because it is soft in nature or prohibitively expensive. Information asymmetry of this nature evolving over time may give the lending bank bargaining power over the borrowing rm, allowing it to extract rents out of the rm. Although the rm has the option of going to other lenders, there may be a stigma attached since other nanciers assume that the previous relationship was terminated for a cause. In that case, uninformed lenders may not be willing to deal with the rm. These barriers to nding competitive lenders can be exploited by the bank to charge higher than normal returns on funds provided or in some other way exploit the borrower. This dark side of relationship banking has been emphasized by Sharpe (1990) and Rajan (1992). This paper combines both the costs and benets of relationship banking in a single framework to provide a rationale for coexistence of bank loans and bonds in rm capital structures. In a survey of 392 Corporate Financial Ocers (CFOs), Graham and Harvey (2000) document that the most important factor aecting corporate debt decisions is managements desire for nancial exibility. Consistent with this evidence, the model in this paper is based on the desire of rms to maintain nancial exibility in their capital structure. Firms engage in costly asset substitution activities for their own benet at the expense of lenders. The presence of an informed lender such as a bank serves to discipline the rm in not indulging in value reducing activities and allows ecient

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 liquidation versus continuation decisions. It is not possible for the bond markets in the model to combat the asset substitution problem and thus nancing through bonds cannot exclusively occur in equilibrium. However, this benet of banks comes with the attendant cost of hold up as discussed above. Firms do not wish to have their project protability eroded due to the monopoly rent extraction activities of the bank. In order to optimally circumscribe the power of the bank, the rm brings in the uninformed lender in the form of bonds in its capital structure. Increased bank monitoring which could be used for rent extraction activities of the bank also acts as a certication device for the bond holders to participate in the lending activity. This positive externality enables contracting of bonds which can then serve to circumscribe the rent seeking behavior of banks. It is also seen that bank loans availability to rms and pricing varies in a non monotonic way across the borrower spectrum. The very low bargaining power rms and the very high bargaining power rms are not aected by the hold up problem of bank nancing. It is too costly for the bank to hold up the former and too dicult to hold up the latter. It is the intermediate rms that are aected most by the dark side of relationship banking and thus stand to benet most by the introduction of bond holders. The model also generates a set of testable empirical implications. Firstly, loan pricing is non linear in the bargaining power the rm. The rate charged by the bank is decreasing in the bargaining power of the rm. Secondly, rms with very high and very low bargaining power follow similar asset substitution policies. Asset substitution is checked more eciently in the case of the rms with intermediate bargaining power. Thirdly, as costs of monitoring increases in the economy, the banks portfolio of loans undergo a change in mix. If bargaining power is considered synonymous with the quality of the rm, the average rm in the bank portfolio is of a lower quality as costs of monitoring increase. Fourthly, the share of bank debt in the rms capital structure should be lower as the rms bargaining power increases. This yields a cross sectional prediction. Also the bank bond spread dened as yield of bond - yield of bank loan is positive, when banks are senior to bonds. Further, it declines in periods when costs of monitoring increase and increases with the value of collateral (a proxy for Liquidation value in the model). With equal seniority of bank loans and bonds, the paper shows that for High Quality Firms, above a certain threshold (proxied for in the model by how often the good project outcome is likely to be realized), the Bond-Bank spread is negative. For rms below this threshold or Low Quality Firms, the opposite is true, (i.e.) the spread is positive. Finally, in nancial systems where the arms length bond markets are not well developed, rms on average should have greater number of bank relationships. Empirically, to the best of my knowledge, the only other paper that looks at yield spreads between bonds and bank loans is Carey (1995). Careys focus is on the eciency of the bank loan pricing market and assumes that the bond markets are ecient and uses the spread between bonds and bank loans to conclude that bank loan markets are ecient as well. Carey compares loan spreads with spread index values of bonds with similar ratings (He also uses a smaller sample

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 where loans and bonds are matched by rm) and also adjusts for collateral, maturity and seniority dierences. In contrast, this paper uses micro data at the rm level and explicitly matches the loans and bonds on all these dimensions and more importantly diers in its focus, on the issues of agency costs, bank specialness and renegotiation. This paper also employs a new econometric methodology on matching developed by Heckman et al (1998) in order to estimate the magnitude of the Bond-Bank spread.

3
3.1

The Model
The Project

Consider a world where all agents are risk neutral and the riskless interest rate is zero. The economy has a single owner-managed rm (henceforth the rm). The rm contacts investors at the initial date 0 to nance its project. Investment in the project requires a xed amount of I dollars at date 0. The assets purchased at date 0 can be liquidated at date 1 for value L where L<I. There is no liquidation value at date 2. The rms project is either good or bad. A good project is always successful and returns G with certainty. A bad project is successful with probability [0, 1] and returns B if successful and 0 otherwise. I assume that Assumption 1 B < L < I < G < B Assumption 1 states that that the good project has a positive NPV, while the bad project has a negative NPV. Further,if known,liquidation is preferable to continuation of the risky project. As of date 0, the type of the project undertaken by the rm is not yet determined. The project type is realized and becomes known to the rm at date 1. The project is good with probability [0, 1] and bad, otherwise. The manufacturing policy or management style followed by the rm (also termed as the -policy) determines the type of project realized at date 1.7 I can thus interpret the policy followed by the rm as the choice of at date 0.

3.2

Lenders

The rm has no money of its own and has to borrow from nanciers to invest in the project. There are two types of lenders in the date 0 market for credit. Credit markets are assumed to be
For example, the rm might consider the manufacture of steel by a tried and tested method (good project) against the alternative of a new, promising but untested method yielding better quality steel, lower raw material consumption etc. (bad project). Firms choices at date 0 determine the likelihood of which project is realized at date 1
7

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 competitive. Banks/Informed/Relationship lenders enter the market at date 0 and date 1 to acquire information and make loans. A bank which makes a loan to a rm at date 0 can obtain information about it by monitoring its activities (more on this below). Much of the information obtained is not veriable or cannot be credibly communicated to a third party (e.g.) a court. Bond Market/Uninformed/Arms length investors lend at date 0 and return at date 2 for their promised payments. I assume that these investors do not monitor the rm, by invoking the standard argument that dispersion of security holders generates either free rider problems or a wasteful multiplication of monitoring costs as in Diamond (1984).

3.3

Information and Contracting Environment

The rm makes an investment I at date 0 and chooses its -policy, which is its private information on this date. The bank does not know the borrowers choice of and in turn chooses its monitoring intensity (also termed as the -policy). The intensity of the banks monitoring activities is denoted by [0, 1]. Then, at date 1, it will learn the true project type realized by the rm with probability ; with probability 1- it will obtain no more than the publicly available information. Monitoring intensity of costs c dollars where c > 0 is the unit monitoring cost.8 The rms -policy becomes public information at date 1 (i.e.) the choice of by the rm is known to the market.9 This structure enables lenders to write covenants against . I assume that it is not possible to write state contingent contracts on the type of project investment, or state realized. Further, I allow only debt contracts, an assumption justied by appealing to the costly state verication technology in Gale and Hellwig (1985). Since any debt contract can be expressed as a linear combination of pure discount debt contracts, I consider only the latter, in this model, to keep matters simple. The discount debt contract involves a borrowing Xi at date i and a single repayment Dij at date j. The following subscripts are used : b denotes bank and m bond market. Thus D02b represents the repayment at date 2 for an amount borrowed from the bank at date 0. The bank debt contract is denoted by a pair (c , Dijb ) where lenders have the right but not the obligation to to liquidate the project if and only if the observed is less than c . Thus c is the covenant restriction imposed by the contract. The bond contract is denoted
This is a simple monitoring technology to bring forth the issues as clearly as possible. Alternatively one might assume that the total monitoring cost is convex in ; to obtain ner information is increasingly expensive. Further, one might reasonably expect that the unit monitoring cost is concave in the amount of loan, reecting economies of scale. In short, total monitoring cost = f ()g (loan) where f is convex and g is concave. All results obtained in this paper with the simpler cost structure survive this alternative specication. 9 This is reasonable, since markets do learn about investment decisions and investment outcomes of rms, albeit with a lag.
8

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 as (Dijm ) with no covenant restrictions. This structure is intended to capture the fact that bank loans have far more restrictive covenants compared to bonds, as noted in Smith and Warner (1979) and Kahan and Tuckman (1996). In summary, the time line of events and information structure is depicted in gure 2. The contract design problem arises in this debt only environment because of moral hazard. While the NPV of the bad project is negative, a borrower is inclined to shift risk to the lenders. I assume Assumption 2 (G I ) < (B I ) Assumption 2 states that that the borrower prefers the bad project to the good one, if nanced by outside investors.

Firms Choice of Financing

Having dened the contracts in the previous section, I begin the analysis of the rms choice of nancing by outlining the main tradeos in the two types of nancing. Under bond nancing there are no monitoring costs. However, the lack of oversight by the nanciers might encourage the rm to aggressively pursue risky investment strategies/manufacturing policies. Under a bank loan, a rms actions are actively monitored. The bank, endowed with superior information and with a greater ability to renegotiate and restructure its loans, will liquidate any realized projects that are negative NPV. However, if the project realized by the rm has a positive NPV, the date 0 contract between the rm and the bank does not oblige the bank to continue to lend at date 1.10 It can use this discretion to hold up the rm and demand a share of the surplus in return for the funds needed to continue the project. The main drawback of bank lending is the ex-post holdup cost that must be borne by the rm.

4.1

Borrowing from the Bond Market

Since the bond markets lend at date 0 and return to collect repayments at date 2, it is sucient to consider the two period debt contract.11 The rm borrows an amount I at date 0 and promises
I assume that bank loans are short term, 1 period contracts which need to be rolled over at the interim date. In contrast bonds are long term, 2 period contracts. later on the model allows for issuance of 1 period bonds. This is consistent with empirical evidence in Tufano (1993) which shows that the average maturity of bank loans is about 5 years while that of bonds is about 10 years. 11 Since the bond markets neither monitor to receive information at date 1 nor act upon the publicly available information, a 1 period debt is equivalent to the 2 period debt contract.
10

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 to repay (D02m ) at date 2. Since there is no monitoring from the bond market, the rm continues the project realized at date 1 regardless of its type. The rm chooses the optimum m by solving max
m , D02m

m (G D02m ) + (1 m )( (B D02m ) + (1 ).0) (1)

be the optimum value for the above problem. The market conjectures the choice of Let m conj chosen by by the rm to be m , and lends I, if it is individually rational, conj conj m D02m + (1 m )(D02m + (1 ).0) = I

(2)

Equation (2) is met with equality due to the assumption of a competitive credit market, and rational expectations equilibrium demands that that the markets conjecture is correct which implies conj . m = m Substituting this and equation (2) in the rm pay o yields, max
m , D02m

m G + (1 m )(B ) I

= 1 and D which implies m 02m = I. However this is not a sustainable equilibrium, as the rm has an incentive to deviate from m = 1 after the loan has been advanced by the bond market. Since (G I ) < (B I ) (due to the presence of rm moral hazard) and the rm cannot be constrained in its activities, it chooses = 0, ex-post. This choice of m m violates lender rationality as the required face value becomes I I D02m = at which point the rm surplus = (B ) = B I < 0, unravelling the equilibrium. In short, the inability of the rm to commit to choosing the good project ex-post after obtaining the funds, in the absence of oversight by the market, causes the exclusive lending from the markets an infeasible proposition in this set up.12 The above discussion is summarized in the following Lemma.

Lemma 1 It is not possible for the rm to borrow exclusively from the market. No equilibrium exists, which simultaneously meets the lender rationality constraint and allows the rm to pursue its optimal investment policy. Proof : See Appendix
In practice, reputation considerations and the need to access markets in the future, might prevent rms from following such a strategy. However both these aspects are outside the scope of this model. See Diamond (1991) for a model which explicitly builds in reputation considerations
12

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

4.2

Borrowing from Banks

I consider the case of a single bank lender. I assume that it is economical for the bank to monitor over the relevant range of picked by the rm at the time of investment. The bank issues a single contract (c , D01b ) specifying the covenant restriction and the debt repayment due at date 1, which may be rolled over based on the negotiations between the bank and the rm. If negotiations break down and the rm is in violation of its covenants, the loan contract confers contingent control rights of liquidation to the bank.13 4.2.1 Denition of Equilibrium at t = 1 and specication of cases

For any given contract (c , D01b ) the rm chooses a and the bank chooses a to maximize their payos. Thus the strategy space is S = . An equilibrium at date t=1 for a given contract is 1. the strategy s S (, ) that maximizes the payos of the bank and the rm

2. such that the beliefs of the bank and the rm are consistent with strategy set S and are sub game perfect and sequentially rational The optimal contract chosen by the rm, maximizes its payo while ensuring that the individual rationality condition is met for the lender. Before I turn the discussion of the various cases that could arise due to a strategy s, I describe the ex-post opportunistic behavior by the bank. At date 1, the project of the rm crystallizes as good or bad and the bank probabilistically uncovers this information by the process of monitoring. In the event, the bank knows that the project is good,it can threaten to not continue the nancing at date 1. This forces a renegotiation game between the bank and the rm to split anew the surplus of the good project returns, which will be realized at date 2. As a result of this bargaining game, the rm gets k(G-L) while the bank gets L+(1-k)(G-L) where the currently exogenous k [0, 1]
In the corporate world where there is default, creditors obtain defacto veto power over any corporate action (Amihud, Garbade and Kahan(1999)). In the model this is interpreted as liquidation of the project
13

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 is the share of the unallocated surplus that the rm gets after bargaining.1415 Proper design of the governing mechanism might ensure the commitment of the bank to re lend, by constraining the bargaining process. However this paper does not focus on these contract design issues (see Aghion,Dewatripont and Rey (1989) and Hart and Moore (1988) for details). Finally it may be noted that it is common knowledge that the rm knows the banks informational status at date 1. I now consider the various cases that arise on this date. The main considerations are (i) the type of project that has crystallized (ii) whether the bank is informed or not and (iii) whether there is a covenant violation or not. I repeatedly use the ideas (a) an informed bank can liquidate any project if there is a covenant violation and (b) an uninformed bank does not liquidate the project as long as the expected payo exceeds L, even though the covenant might have been violated. Project turns out to be good and the bank is informed The bank holds up the rm and they split the surplus based on their bargaining power as described above Project turns out to be good and the bank is uninformed Based on the publicly available information on , the bank calculates the probability of repayment P() of the loan = ( + (1 ) ). If P()D01b L, letting the project continue is more protable than liquidation and vice versa. In the case of liquidation which is costless in this set up, the bank captures the entire proceeds L16 Project turns out to be bad and the bank is informed If there is a covenant violation, the bank acts eciently, liquidating the project and capturing the surplus L B , over the negative NPV project, and is thus value enhancing. The rm cannot commit to liquidation at date 1 if the bad project were to be realized. If there is no
The parameter k can be thought of as the result of this background bargaining game between the rm and the bank. As the rm approaches the bank for continuation nancing it can propose a sharing rule for the surplus as the bank does not respond otherwise. If the rm is liquidated all payos accrue to the bank and thus the rm can do strictly better by renegotiating. Further assume that a delay in obtaining continuation nancing hurts the rm more than the bank (i.e. the bank is more patient) and that the returns from the project decays if there is a delay in its implementation. For example, competition from the product market could cause a decay in returns if the project is delayed. In such a situation the bank can wait until the moment when the project value falls to the value of the debt repayment and oer continuation nancing. The rm can do no better than accept. If I know the discount rates which is accepted as an exogenous primitive for the bank and the rm, I can determine the share of the surplus obtained by the rm. 15 One can also think of this situation as a line of credit advanced by the bank to the rm, callable at the banks discretion 16 It is not possible for a good project rm to credibly reveal its project at date 1 to the bank if the latter is uninformed. This is because no signalling equilibrium exists in this set up and each type can always mimic the other type. If there is a covenant violation, a bad project rm can always mimic the good and vice versa
14

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 covenant violation, the rm and the bank bargain and split the surplus L B such that the rm gets a payo greater than (B D01b ). Project turns out to be bad and the bank is uninformed This case is similar to to the second case.17 The bank liquidates the rm if P()D01b < L and lets it continue otherwise, based on , the public information at date 1. I enumerate two cutos min and max , such that P(min )G = L and P(max )D01b = L and summarize the above discussion as the payos of the rm (X) and the bank (Y). Notice that the bank will set a covenant c at least as stringent as max in its contract. X (, ) =

(1 )(G + (1 )B P ()D01b )+ ( k (G L) + (1 )( (B D01b ) + k (L B ))) (1 )(G + (1 )B P ()D01b )+ ( k (G L))

[c , 1]

[max , c )

(1 )(G + (1 )B P ()D01b )+ ( k (G L)) ( k (G L))

[min , max )

[0, min )

Note that an uninformed bank simply liquidates the rm if (0, min ] as P()D01b < L in this range. If falls in (min , max ], the rm and the bank know that P()D01b < L. However the rm can oer a new repayment D01b at date 2 such that P()D01b = L and D01b L. The bank then accepts this repayment schedule and lets the rm continue the project. The payo of the bank is summarized as under :
In this case the good project rm mimics the bad project rm, trying to get a payo X > (B D01b ) > (GD01b ). Thus signalling by the bad project rm to get itself liquidated is not eective here.
17

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Y (, ) = (1 )(P ()D01b ) c+ ( (L + (1 k )(G L)) + (1 )(D01b + (1 k )(L B ))) (1 )(P ()D01b ) c+ ( (L + (1 k )(G L)) + (1 )L) [c , 1]

[max , c )

(1 )(P ()D01b ) c+ ( (L + (1 k )(G L)) + (1 )L) (1 )L c+ ( (L + (1 k )(G L)) + (1 )L)

[min , max )

[0, min )

Having characterized the payo of the bank and the rm, I turn to the solution which outlines the strategy of the rm and the bank and the optimal contract oered in equilibrium. It is useful to record the following result, while searching for the optimal policy of the rm. Lemma 2 The rms optimal choice of lies in the closed interval [max , c ] Proof : See Appendix Lemma 2 establishes the limits on the optimal manufacturing policy that can be followed by the rm. Since c is the covenant set by the bank, it does not pay the rm to over comply with the restriction (i.e.) pick a > c . This establishes the upper limit on . At the same time, the rm does not want to get liquidated or oer a higher face value to avoid liquidation, if the bank is not informed at date 1. Accomplishing these objectives improves the payos of the rm, and the lowest that enables the rm to do so is max dened such that P(max )D01b = L. Lemma 2 states that the optimal policy of the rm has to lie between these limits. Using the payo functions X and Y and Lemma 2 it is now possible to characterize the equilibrium for the case of bank borrowing. Note that the individual rationality condition for the bank implies P()D01b = I . Proposition 1 (Bank Borrowing Equilibrium) There exists an unique optimal single bank ). The manufacturing policy and the monitoring intensity of the rm contract ((c ) , D01 b and the bank respectively, are also unique. They are given by 1. (c ) = 1
I (1k)(GL) = 2. D01 b (I +cL)(1 )+ (1k)(GL)

3. =

I +cL) (1k)(GL)

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 4. =


1 k(GL)A 1+ (1)I (1k)(GL)(GB )A

where A = (I + c L) (1 ) + (1 k )(G L) Proof : See Appendix Proposition 1 assumes implicitly that the rm with the good project is being held up by the informed bank at the time of loan renewal at date 1. The bank would hold up if the pay o from this strategy L + (1 k )(G L) exceeds D01b , the payo with no hold up. Intuitively the proposition says the following The bank wishes to obtain full control rights to liquidate the project if it turns out to be bad. This can be ensured only by setting the strictest possible covenant in this model (i.e.)(c ) = 1. If the bank were to set a relaxed covenant, and the rm adhere to it, the former lacks the control rights and cannot unilaterally liquidate the project, were the bad project to be realized. The bank has to induce the rm to voluntarily liquidate the bad project by sharing some of the liquidation surplus with it. Setting the strictest covenant obviates this possibility. It also means that covenants are always breached in equilibrium. This is not necessarily a bad thing, since decisions are driven completely by incentives and renegotiation in this set up. From now on we set (c ) = 1 in the model. Monitoring benets the bank in two ways : For a good project an informed bank extracts rents by holding up the rm. In the case of a bad project, liquidation enables it to capture the surplus L B . The bank chooses the level of monitoring which drives the marginal return to risk shifting of the rm to zero while maximizing its benets. The rm faces the hold up cost of a good project and liquidation losses of the bad project, if it is confronted by an informed bank (notice that these are the benets of the bank listed above). An uninformed lender enables it to enjoy benets from the good project and returns to risk shifting from the bad. The rm thus chooses the optimum level of risk shifting to drive the banks value from monitoring to zero. The optimal debt value, conditional on the rms - policy is then driven by the competitive =I credit market rationality condition P( )D01 b I now turn to the optimal policies of the rm and the bank, when the bank does not nd it worthwhile to hold up. This implies the payo from hold up is less than the payo from not holding up, for the bank: L + (1 k )(G L) D01b which is equivalent to (G D01b ) k (G L) The inequality condition is satised for 2 combinations of k and D01b . The rst is low k and high D01b and the second is high k and low D01b . The rst case corresponds to that of a rm with

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 very low bargaining power. Low bargaining power does not provide sucient incentives to pick the good project (i.e the rm follows a low -policy) as most of the returns from it would be usurped by the bank. This consequently raises the face value of debt demanded by the bank further reinforcing the inequality. The second case corresponds to that of a rm with very high bargaining power. Thus holdup is not an issue with these rms. These rms can follow a high -policy leading to a low face value of the debt, further reinforcing the inequality. What is the optimal policy of the rm and the bank in the absence of hold up? Lemma 3 answers this question. Lemma 3 The optimal policies of the rm and the bank in the absence of hold up is given by 1. =
c) (LD01 b ) (LD01 b ) (GD01 b ) (B D01 b

2. =1-

= min( a 3. D01 b

a2 4IL ), 2

such that I D01 b G where a = I + L c(1 )

Proof : Similar to Proposition 1 and hence omitted Proposition 1 and Lemma 3 delineate the optimal policies of the bank and the rm in the presence and absence of hold up respectively. It is intuitively clear from the discussion preceding Lemma 3 that both high and low k rms are not aected by the banks information monopoly leading to a hold up problem. How high or low should k, the bargaining power be in order to be not aected by the bank? I turn to Proposition 2 which states the borrowing patterns of the continuum of rms, indexed by the parameter k, the bargaining power. Proposition 2 (Patterns of Bank Borrowing) occurs in equilibrium. 2. For k 3. 3. For k 4. For k 1. For k [0, k ) no lending and borrowing

[k, kcrit ) the bank does not hold up the rm and the equilibrium is given by Lemma

[kcrit , k ) the bank holds up the rm and the equilibrium follows proposition 1. [k, k + ) no lending and borrowing occurs in equilibrium.

5. For k [k + , 1] the bank does not hold up the rm and the equilibrium is per Lemma 3. The expressions for the cuto points are as under (a) k = max[1 (b) kcrit = k x
(I +cL)(1 )G (GL)(I G) , 0] L)c(1+ ) where x = e(I 2 (GL)

and e = c2 (1 )2 2c(1 )(I + L)+(I L)2

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 (c) k =


(GI c) (GL) (GI ) (GL)

(d) k + =

Proof : See Appendix The reasoning behind this proposition is best explained by considering an example. Example 1 Let L = 1.8, I = 2, G = 2.5, B = 3.5, = 0.4 and c = 0.2 satisfying assumptions 1 and 2. The critical cuto points are given by k = 0.143, kcrit = 0.259, k = 0.429 and k + = 0.714. If the bargaining power of the rm is very low, it does not have sucient incentives to undertake the good project as most of the returns are garnered by the informed bank. The rm undertakes the bad project (asset substitution) and forces the bank to demand a higher face value of debt to break even. However, the face value of debt cannot exceed G, and this limits the set of rms that are able to obtain nancing. For k < 0.143, no rm is able to borrow from the bank. For k between 0.143 and 0.259, the returns to the bank by holding up are lower than the returns from not holding up. Thus the no hold up solution of Lemma 3 applies to all rms, in this region. The optimal choice of the rm and the bank is shown in gure 3 (The two regions are labelled A and B). As k increases further, holdup is protable to the bank and the optimal choices are characterized by proposition 1. For k [0.259, 0.429) the rms choice of increases as its bargaining power increases and the banks monitoring intensity decreases as the good project is more likely to materialize. approaches 1 at the upper limit of this interval (Region C). The face value of the debt demanded by the bank falls towards I making the loan, virtually a risk-free proposition. However at = 1 , the banks incentive to monitor disappears as it can save on the monitoring cost and yet prevent the rm from engaging in asset substitution. This deviation causes the rm to deviate from its choice of = 1, as it cannot be caught by the bank and liquidated, if it were to undertake the bad project. This unravels the equilibrium and no feasible solution exists in the interval [0.429,0.714) (Region D in gure 3). As the bargaining power of the rm increases further beyond 0.714, hold up by the bank is no more an issue, and once again Lemma 3 applies. This solution relates to region E in gure 3.
Since P( )D01 b = I , the price of a bank loan contract in this set up can be represented as 1 rbank = P ( ) 1, where P( ) = + (1 ) . By inspection of in gure 2, it is immediately clear that loan pricing is highly nonlinear in the bargaining power of the rm, a testable empirical implication of the model. 1 P ( )

Corollary 1 The price of bank loan for a dollar lent to the rm at date 0 is loan pricing is nonlinear in the bargaining power of the rm.

1. Further

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 I now turn to the issue of comparative statics on the optimal policies of the the rm and the bank when hold up is an issue for the rm (i.e.) study behavior in the [kcrit , k ) region. Further what is the economy wide implication on how the type of rms that obtain bank loans, change in this set up? Stated dierently what is the eect of an increase in costs of monitoring c on the various cut o points identied in proposition 2? Proposition 3 provides answers to these questions. Proposition 3 (Comparative statics) Let k tion 2. Then [kcrit , k ) where kcrit , k and are given by proposi-

1. The rms optimal manufacturing policy is increasing in k 2. The banks optimal monitoring intensity is decreasing in k
are decreasing in k 3. The price of bank debt rbank and the face value of debt D01 b

Let k [0, 1]. An increase in bank monitoring costs c, causes the critical cut os of proposition 2 to change. In particular (a) k and k are decreasing in c (b) kcrit is increasing in c (c) k + is independent of c Proof : See Appendix The reasoning behind the rst part of the proposition is as follows. As the rm becomes more powerful in the bargaining process vis-a-vis the bank, it can capture a larger share of the surplus. This incentivizes the rm to choose the good project with a higher probability. Consequently the banks intensity of monitoring falls as it can extract less by holding up in the good state. A higher probability of choosing the good project, also causes a reduction in the price of bank debt and the face value of debt demanded by the bank, as expected. The second part of the proposition is illustrated in gure 4. Increases in monitoring costs causes the intensity of monitoring to decline thus weakening the hold up problem. At the same time it increases the incentive of the rm to engage in asset substitution. However the expected increase in payo to the rm due to the reduced hold up problem, if the good project is realized, outweighs the expected increase in payo by asset substitution. Consequently a rm on average with the same bargaining power picks the good project more often. This shrinks the region of hold up and increases the region of no hold up. Thus, more rms with very low bargaining power are granted credit by the bank. The range of rms with high bargaining power which were not aected by the hold up earlier remains unaected as the threshold is independent of c (Region E). This along with the fact that k (rms pick a higher on average) decreases causes an increase in the range of rms in Region D where there is no lending by the bank. Thus an increase in monitoring costs causes a decrease in lending in Region D.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

4.3

Borrowing from both Banks and Bond markets

Having outlined the cases of exclusive borrowing from the bond markets and banks, in the previous sections, I now consider simultaneous borrowing from both sources of nance. First I consider the case where bank loans are senior to bonds (The case when both bank loans and bonds have equal seniority is analyzed later). Let s be the proportion total funds required (which is I) that is borrowed from banks and the balance 1-s is borrowed from bond holders. The face value of 1 period bank debt and 2 period bonds is denoted by D01b and D02m respectively. Further, assume D01b > L. If D01b L the bank can always demand liquidation and will be made whole, destroying the incentives to monitor. In such a situation an outside nancier cannot participate in funding as illustrated in Lemma 1. An argument along the lines of Lemma 2 establishes the rms optimal choice of in the interval [max , c ]18 . The payo for the rm(X), bank(Y) and bondholders(Z) is outlined as under : X (, ) := (1 )(1 ) (B D01b D02m ) + ( k (G L) + (1 )(G D01b ) D02m ) Y (, ) := (1 )(L + (1 )D01b ) + ( (L + (1 k )(G L)) + (1 )D01b ) c Z (, ) := (1 )(1 )D02m + D02m The individual rationality conditions for the bank loan and bonds due to a competitive credit market implies P()D01b = sI P()D02m = (1 s)I An equilibrium solution provides the values of the ve variables in the model (, , D01b , D02m , s). Proposition 4 characterizes this equilibrium. Proposition 4 (Bank Bond Equilibrium) There exists an unique equilibrium in mixed nancing of bank loans and bonds. The optimal values of the parameters are given by 1. =
(I +cL) (GL)

2. () = 1
18

I further set the covenant c = 1 for reasons discussed earlier

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 3. s = 1 k


k(cL) I

=k (G L) 4. D02 m I (1k)(GL) = 5. D01 b (I +cL)(1 )+ (1k)(GL)

Proof : See Appendix Proposition 4 has interesting implications on the monitoring activities of the bank. The bank advances only a share s of the total investment I compared to the total outlay of I in the single bank case (in proposition 1). However, its monitoring intensity increases to 1 from in the single bank case. Intuitively, the bank becomes the senior lender compared to bonds in the capital structure of the rm. Thus its liquidation rents L remain unchanged compared to the single bank case but is however contingent on detecting the bad project realization and liquidating it. The presence of uninformed bond holders increases the risk shifting incentives of the rm compared to a rm that has been fully nanced by the bank. This can be seen by the lower value of compared to the single bank case. This incentivizes the bank to monitor more intensely as the bank is able to detect and liquidate value reducing projects (generated by the risk shifting activities of the rm) only by the process of monitoring. The osetting eect is the reduced ability of the bank to hold up the rm and extract rents if a good project were to materialize, due to the presence of bonds in the capital structure. However the rm chooses the optimal amount of bank debt to obtain ecient liquidation benets and yet circumscribe the power of the bank to hold it up. Proposition 4 says that the banks incentives are sucient enough, to invest in full monitoring. This result has important implications to the ongoing debate on the development of bond markets in Europe. There are concerns expressed that as the bond markets develop in bank dominated nancial systems such as Germany, banks might have less incentives to invest in the oversight of the rms. Proposition 4 suggests that such concerns might be misplaced. Further comparing Lemma 1 and Proposition 4, it is clear that presence of bank debt in the rm capital structure facilitates the contracting of bonds. While banks use their proprietary and soft information from monitoring to hold up the rm, there is positive externality to monitoring. Bank monitoring provides the necessary certication needed by the bond market to step in and participate in the nancing. This in turn limits the rents that the bank can extract with the good project. The rm chooses the optimal amount of bank debt such that marginal net benet of choosing an extra dollar of bank debt equals 0. The rm also chooses an optimum level of which is lower compared to the in Proposition 1 (single bank case). This is because, the residual risk of asset substitution is now borne by the bond holders and fairly priced. It is now possible to compute the prices of bonds and bank loans in the model. Further based on these prices the bond bank spread dened as the price of bond - price of bank loan can be explicitly derived. Lemma 4 collects these results and also the comparative statics.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Lemma 4 The bond bank spread is dened as
D02 m (1s)I

(GL)(GI c) = (I +cL)(( I +cL)(1 )+ (GL)) and is positive. F urther and L > 0

D01 b sI c <

Proof : See Appendix Banks in the model have the benet of seniority while bonds do not. This eect outweighs the fact that banks incur a cost of monitoring. Seniority drives down the price of bank loans compared to bonds while the high cost of monitoring drives it up. Since bond holders do not have this net benet they require a higher compensation compared to the bank causing the bank bond spread to be positive. As costs of monitoring increase, the price demanded by the bank begins to increase, driving the spread down. As liquidation value increases, the bank by virtue of its seniority captures the full benets of liquidation. This causes the bank bond spread to widen. The analysis of the bond bank equilibrium assumed the seniority of bank loans with respect to bonds. However as a practical matter, seniority of bank loans implies higher recovery rates at the time of default and advantages in the reorganization process during bankruptcy, which could aect the Bond-Bank spread in ways other than what is identied in this paper. Thus the Bond-Bank spread is characterized for the case when both bonds and bank loans are equally senior. The main dierence in the analysis is that at the hold up stage, the banks threat point is s.L the share it can get by liquidation when it is pari passu with bonds compared to L in the senior case. Lemma 5 records the result. Lemma 5 Consider the case when bank loans and bonds are equally senior. The bond bank spread D01 D02 m b is dened as (1 s)I sI =
L (1) 1 I ( +(1 ) ) (

), where = and k =

I (1 ) ( L

1)

Dene s =

I +cG L(1 )

I (1s )c I Ls )

Then >

s < s

k > k

If k [kcrit , k ) then 1. If > , then , the Bond-Bank spread is < 0 2. If < , then , the Bond-Bank spread is > 0 If k [kcrit , k ) then , the Bond-Bank spread is > 0 Proof : Follows along the lines of proposition 4 and lemma 4 and hence omitted.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 In order to develop intuition for this result, I rewrite the rst order condition of the bank as under [sL + (1 k )(G sL) Db ]
expected expost holdup benef its f or the bank

c
monitoring costs

(1)s(1 ) +(1)

[ ]

Thus the sign of the bond-bank spread depends on the relative importance of the expected ex-post hold up benet vis-a-vis the monitoring cost. Higher monitoring costs drive up the yield on bank loans relative to bonds. Higher ex-post hold up benets for the bank serve to lower the ex-ante yield on the bank loan relative to bonds. The relative importance of these two eects determine the sign of the Bond-Bank Spread. When the monitoring costs dominate the expected ex-post hold up benets, bank loans have a higher yield than bonds thus causing the bond-bank spread to be negative. When the the expected ex-post hold up benets dominate monitoring costs, bank loans have a lower yield than bonds thus causing the bond-bank spread to be negative. in the model is the probability with which the good project outcome is likely to be realized. > can thus be thought of as a good quality rm. > is a rm with a bargaining power k which is at least k . Such a rm is aected less by the ex-post hold up problem because of its high bargaining power. For the bank lending to such a rm, the ex-post hold up benets are outweighed by the cost of bank monitoring. Thus bank loan yields are higher than that of bonds, causing the spread to become negative. < can be thought of as a poor quality rm. < is a rm with a bargaining power k which is at most k . Such a rm is aected more by the ex-post hold up problem because of its low bargaining power. For the bank lending to such a rm, the ex-post hold up benets are higher than the cost of bank monitoring. Thus bank loan yields are lower than that of bonds, causing the spread to become positive. Recall from Proposition 2 that the ex-post hold up by the bank is an issue only for rms whose bargaining power k [kcrit , k ). The above analysis considered the case when the critical cuto k where the Bond-Bank spread changes its sign, lies in this interval. A second possibility is that the critical cuto k enumerated above lies outside the upper limit of this interval. In such a case for all values of k [kcrit , k ), the ex-post hold up benets of the bank are higher than the cost of bank monitoring. Thus bank loan yields are lower than that of bonds, causing the spread to become positive for all values of . Both of these cases are depicted in gure 4b. The above empirical implications are then tested in the data, with credit rating as a proxy for the quality of the rm. Hitherto in the analysis k the bargaining power of the bank was considered exogenous. The next section formally models the bargaining game between the bank and the rm and endogenizes bargaining power

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

4.4

Endogenizing Bargaining Power k

I model explicitly the bargaining game between the Bank (Player A) and the Firm (Player B) at the intermediate date 1 when the bank holds up the rm for rents after the good project has been realized and is common knowledge. The two players in the game bargain over a cake of size = G D02a according to the following, alternating-oers procedure. Player A begins by making an oer to Player B. An oer is a proposal of a partition of the cake. Player B can respond to the oer by (i) accepting the oer, (ii) rejecting the oer and making a counter oer time units later, and (iii) reject the oer and opt out, in which case negotiations terminate in disagreement. Player B while bargaining continues to search for an outside option (in this case the possibility of raising money from the bond market) and has to immediately accept or reject such an option should it arise, in the model. This model is appropriate as Player B need not physically leave the negotiations with Player A while conducting the search process. Player A can respond to the oer from Player B by (i) accepting the oer, (ii) rejecting the oer and making a counter oer time units later. The outside option for Player B in this case is the ability to successfully raise funds from the bond market at date 1 in order to continue the project. The probability of success is assumed to be p. Thus the negotiations between Player A and B break down with probability p, the measure of Player Bs ability to raise nances in the bond market in any time period. Let xA and xB be the shares of the cake (< ) from bargaining and A and B be the discount factors (< 1) for Players A and B respectively. A sub game perfect equilibrium of the bargaining process is such that (i) Whenever a player has to make an oer, her equilibrium oer is accepted by the other player (no delay) and (ii)In equilibrium, a player makes the same oer whenever she has to make an oer(stationarity). Let x A and xB denote the equilibrium oers. Then,
x B = A x A This equation states that Player A is indierent between accepting and rejecting Player Bs equilibrium oer. To see this consider an arbitrary point in time when player B has to make an oer to player A. By the properties of no delay and stationarity it follows that player As equilibrium payo from rejecting any oer is A x A . This is because by stationarity, A oers xA after rejecting any oer which by the principle of no delay is accepted by Player B. Sub game perfection requires that player A accept any oer xB such that xB > A x A , and reject any oer xB , such that xB < A xA . Further more it follows from the property of no delay that x B A xA . However, x B A xA ; otherwise player B could increase his payo by instead oering xB such that x B > xB > A xA ;

By a similar symmetric argument with the roles of A and B reversed and noting that B has an outside option of value y

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31


x A = (1 p) B xB + p y In order to simplify further I assume A = B = Solving these two equations simultaneously for a unique solution, I obtain, x A = and

py (1p) 2 (1(1p) 2 )

py +(1 ) x B = 1(1p) 2 y is the payo to the rm if it successfully raises funds from the bond market and pays o the bank at date 1. For simplicity I assume oatation costs are negligible. Let D12a be the repayment to bond holders at date 2 for funds amounting to D01b raised at date 1. By lender rationality ( + (1 ) )D12a = D01b . Then y = G D02a D12a .

Enumeration of rm payos (I now revert back to the original assumption of bank loans being senior to bonds) The payo to the rm X (, ) = [x B ]+(1 )[ p (B D02a D12a )]+(1) [GD01b D02a ]+(1)(1 )[ (B D01b D02a ] The payo to the bank Y (, ) = [x A ] + (1 )[ p D01b + (1 p) L ] + (1 ) [D01b ] + (1 )(1 )[D01b ] c The payo to the bondholders Z (, ) = D02a + (1 )D02a As before let s be the share of bank loans and 1 s the share of bonds in rm capital structure. Optimization of the individual payos and competitive credit markets supply the following equations. x B + (1 )[G D01b D02a ] p [B D02a D12a ] (1 ) [B D02a D01b ] = 0 x A D01b + (1 )[pD01b + (1 p)L] (1 ) D01b c = 0 ( + (1 ) )D02a = (1 s)I Y = sI
X D01b

=0

x B D01b

= 0 ( + (1 ) )(1 ) = 0

( + (1 ) )D12a = D01b I further simplify the calculations by assuming p =1. Proposition 5 characterizes the solution.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Proposition 5 (Endogenous Bargaining Power) The optimal policies to the investment problem faced by the rm when faced with the bargaining game is given by the solution to the following equations 1. 2. 3. = 1 D01b = f (s) = = g (s) =
I 2

[1

2 ]

[1
1

2 2 ]

+ 4s[( 2 )G B ]

s (1 )

q 2 [1 2 ]+ [1 2 ] +4s[( 2 )GB ]

s I (1 ) 2f (s)

4. 5. 6.

D02a = f (s) D12a =


sI f (s) G(1

(1s) s

(f (s))2 sI

and
(f (s))2 sI s) + (1 s f (s) +

f (s) 1 I (1 s) G (1 1 ) + ) f (s) sI (2 ) c(1 ) = 0

Solving for s from the last equation enables computation of all other variables in the model. Proof : By Simultaneous solution of the equations listed above So far I have considered the use of bond markets by the rm to optimally circumscribe the power of the bank and achieve nancial exibility. Can multiple banking relationships achieve the same eect? This question is addressed in the next section.

4.5

Borrowing from Multiple Banks

For simplicity I consider the case of 2 identical banks each lending I/2 to the rm at date 0. They are also assumed to have the same unit monitoring cost c and undertake independent monitoring. The key dierence in the analysis arises when both banks are informed about the good project. The incentive to collectively hold up the rm disappears in this case as one bank can gain by unilaterally deviating from the hold up coalition with the other bank. Thus competition between symmetrically informed banks eliminates the hold up problem. Since the banks are identical in all respects, their choice of monitoring and face value of debt demanded will be identical. Monitoring is independent,identical and non cooperative to rule out free rider problems. Let be the monitoring 01b the face value of debt. Further by the result of Lemma 1, I limit intensity chosen and D2

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 the analysis to the region [max , 1]. The payo of the rm (X), Bank1(Y1) and Bank2(Y2) are summarized as under19 X (, ) := (1 )(1 )2 (B D01b )+ 01b L + (2 + (1 )2 )(G D (2(1 ) k G D2 01b )) 2
2 D01b Y1 (, ) := (1 ) L 2 (1 ) 2 D L L 01 b 01b ) c (2(1 ) 2 + (1 k ) G 2 2 + 2 + (1 )2 ) D2

Y2 (, ) := Y1 (, )
) for the multiple bank lending case. Proposition 6 characterizes the solution triplet ( , , D01 b

Proposition 6 (Multiple Banking Relationships) Let there be 2 banking relationships sustained by the rm. The optimal policies to the investment problem faced by the rm is given by the solution to the following set of simultaneous equations 1. =
)2c (1 )(LD01 b (1k )(2GD L)) (1 )((1 )D01 b 01b

2. ( )2 (1 E L) k (2G D01 b
=I 3. P( )D01 b

) (B D01 b

)+

) (B D ) (GD01 b 01b E

) (B D ) = 0 where E = 2(G D01 b 01b

where

P( ) = + (1 )

Proof : See Appendix It can be seen from Proposition 6 that = 1 is not a solution to this system of equations. Thus the monitoring intensities in a multiple banking relationships are always lower than the single bank case. Further it follows that if < 1 , there exists states of the world when one bank is informed and the other is not. The informed bank can then continue to hold up the borrower thus not fully eliminating the hold up problem faced by the rm. In this sense, multiple banking relationships are not as eective as bond markets in resolving the hold up problem. Thus rms with these two alternatives to mitigate the hold up problem would favor the bond market alternative. Those rms which do not have this access would resort to multiple banking relationships. This leads to the testable empirical prediction that in nancial systems where the arms length bond markets are not well developed, rms on average should have greater number of bank relationships.
Note that there are 4 cases to be considered. Both banks are either informed or uninformed, and case where one is informed and the other is not as a result of their monitoring eorts
19

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

Empirical implications

I summarize the main empirical implications of the model. In these implications, rm quality indicated by credit rating might be considered as a reasonable proxy for the bargaining power of the rm Loan pricing is non linear in the bargaining power the rm. The rate charged by the bank is decreasing in the bargaining power of the rm. Firms with very high and very low bargaining power follow similar asset substitution policies. Asset substitution is checked more eciently in the case of the rms with intermediate bargaining power. As costs of monitoring increases in the economy, the banks portfolio of loans undergo a change in mix. If bargaining power is considered synonymous with the quality of the rm, the average rm in the bank portfolio is of a lower quality as costs of monitoring increase. The share of bank debt in the rms capital structure should be lower as the rms bargaining power increases. This yields a cross sectional prediction. The bond bank spread dened as yield of bond - yield of bank loan is positive when bank loans are senior to bonds. Further, it declines in periods when costs of monitoring increase and increases with the value of collateral (a proxy for L in the model). The bond bank spread dened as yield of bond - yield of bank loan is negative for high quality rms and positive for low quality rms when bank loans are equaly senior to bonds. Alternatively for certain parameterizations of the model, the Bond-Bank spread is always positive for all rms. In nancial systems where the arms length bond markets are not well developed, rms on average should have greater number of bank relationships.

Sample Selection and Data

I obtain yield information on bank loans from 2 sources : LPC Goldsheets which is a weekly trade publication of Loan Pricing Corporation and LPC Dealscan database containing data on loan facilities originated by US banks. In order to ensure comparability with bonds, I consider bank loans which are either term loans or revolvers greater than one year. Further only loans whose stated purpose is either corporate purposes or debt repayment is considered for inclusion in the sample. By construction special purpose loans are excluded from the sample. For the same rm, at the

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 same point in time, data on bond yields are obtained from 3 sources : (i) Gold Sheets (ii) The Bond Data Pricing Set (Fixed Income Research Program) part of the Fixed Income Securities Database (FISD) and (iii)Yield Book, the xed income database of Salomon Analytics Inc used by Salomon Smith Barney (http://www.yieldbook.com). Bank Loan data from Dealscan and Goldsheets are hand matched by rm name to FISD and Yield Book databases to obtain bond information. Only exact name matches were considered for inclusion in the data sample. Wherever it is not possible to obtain market determined yields on the same date for the corresponding bond, I use the yield on the closest date available. Further I consider bond yields based on dealer quotes or actual transactions and eliminate all matrix prices from the sample. The data set spans the years 1991 - 2001 with the majority of the observations coming from the 1995-2001 period. I attempt to match rms loans and bonds primarily on 4 dimensions - (i) Credit rating (ii) Remaining Maturity (iii) Seniority Class and (iv) Collateral. For each loan the closest maturity bond that is available with the same credit rating and seniority class is chosen and the yield on the date of interest is obtained from the database. I ensure that the bonds dont have special features such as puttability. Sample C1 is obtained directly from the relative value market a weekly feature of Goldsheets which tracks the loan and bonds of the same rm. In order to ensure that I obtain the ratings for the loans and bonds at the time when the yields are observed and not when the ratings were assigned, I obtain rating information from Moodys website (http://www.moodysresearch.com) and the Yield Book database. Sample C3 is the cleanest sample which matches loans and bonds on all the 4 dimensions and contains 147 observations. Samples C1,C2 and C4 match loans and bonds on all dimensions except collateral. Loans in the samples are collateralized while bonds are not. All together I obtain 7,640 matched pairs or 15,280 observations on yields . Out of these 5,665 pairs have an exact match on the broad rating class and are also matched on seniority and maturity dimensions as closely as possible. Table 1 summarizes the data sources used in the study.

6.1

Computation of Bond Bank Spread

All loans in the sample are priced using oating rates with LIBOR as the reference rate. Bonds in contrast in the sample are xed rate instruments. First I obtain the yield on a treasury bond with comparable maturity to that of the corporate bond and calculate the bond spread over treasuries.20 In order to make the two yields comparable on the same scale to calculate the Bond Bank Spread, I assume that lenders fund loans and bonds with liabilities having the same rate type or to arrange interest rate swaps that eliminate any interest rate risks. The cost of such a strategy is assumed to be the interest rate swap spread. A bank making a oating loan to the rm may
20

Due to computational burdens in the construction of the sample by hand, duration matching was not attempted

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 replicate the same eect by buying a package of the rms bonds and arranging a standard interest rate swap. In the absence of transactions costs and dierences in other terms, forces of no arbitrage would cause the spreads on these two investments to be equal. Thus bond spreads are adjusted to a oating rate LIBOR equivalent basis by subtracting an appropriate swap spread for that maturity under consideration. I obtain swap spreads for each maturity from the Yield Book database. For maturities not covered by the database, linear interpolation is used to obtain swap spreads.

7
7.1

Methodology and Empirical Results


Methodology

This study uses matching which is a widely-used method of evaluation. This empirical exercises methodology is similar to that of the literature in medicine and statistics. It is based on the intuitively attractive idea of contrasting the outcomes (yields) for a bank loan to that of a bond. Dierences in the yields can then be attributed to the ability of banks to renegotiate and monitor. Thus the yield spread is a measure of the value of renegotiation or the value added by the banks. Alternatively it is the premium desired by the bond holders who are not in a position to mitigate agency costs by their inability to monitor and renegotiate. Thus the spread is a measure of the agency costs of debt of the rm. Sample selection criteria is thus used as a principal method for achieving comparability and appropriateness. In the nance literature, matching is not often used by economists21 . Firstly, it is dicult to determine if a particular control group is truly comparable to that of the participants. Heckman, Ichimura and Todd (1997,98) show that it is essential to meet certain conditions encompassing the data and the matching method in order to substantially reduce bias in non experimental estimates. They include : (1) Controls and participants have the same distribution of observed personal characteristics (2) Outcomes and characteristics are measured in the same way for both groups and (3) Participants and controls are placed in the same economic environment. In the application I consider, Bonds can be thought of as the participants and Bank Loans as the control group. In the current case conditions (2) and (3) are met rather well, as market determined yields for both bank loans and bonds are compared at the same point in time. Further the matching method attempts matches on personal characteristics (Seniority,maturity, ratings and adjustment for collateral in this case) as closely as possible between loans and bonds in order to meet condition (1). Thus the method of collecting the sample and matching each loan and bond can produce a simple estimate of the yield dierence between bonds and bank loans which is the focus of this paper. This dierence
Notable exceptions include Barber and Lyon (1996), Villalonga(2000) and Conrad, Johnson and Wahal (2000). However these papers do not use the Heckman et al (1998) methodology
21

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 is then attributable to the measure of agency costs, bank specialness and renegotiation. I now turn to formal econometric methods of matching in order to estimate the yield dierence between bank loans and bonds. The evaluation problem is estimating the causal eect of using public bonds (the treatment) over bank loans on the Yield Spread (the outcome) experienced by rms in the population of interest. Let Y1i denote the yield spread of bonds of rm i and Y0i denote the yield spread of bank loans of rm i. The object of interest is the mean eect of excess spread of bonds over bank loans, with characteristics X: E (Y1 Y0 | D = 1, X ) (P 1)

where D = 1 denotes the treatment (i.e.) in this case a bond not being bound by strict covenants and not able to be easily renegotiated. The mean E (Y1 | D = 1, X ) can be identied from data on bonds. Assumptions must be invoked to identify the counterfactual mean E (Y0 | D = 1, X ). The outcome E (Y0 | D = 0, X ) is used to approximate E (Y0 | D = 1, X ). The selection bias that arises from this approximation is B (X ) = E (Y0 | D = 1, X ) E (Y0 | D = 0, X ) The method of matching solves this evaluation problem. We begin by assuming that all relevant dierences between bank loans and bonds are captured by their observables X (Heckman and Robb (1986)). Using the notation let (Y0 , Y1 ) D | X (A 1)

denote the statistical independence of(Y0 , Y1 ) and D conditional on X. An equivalent formulation of this condition is P r(D = 1 | Y0 , Y1 , X ) = P r(D = 1 | X ) Rosenbaum and Rubin (1983), henceforth denoted RR, establish that, when (A-1) and 0 < P (X ) < 1 (A 2)

are satised, (Y0 , Y1 ) D | P (X ), where P (X ) = P r(D = 1 | X ). Conditioning on P(X)

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 balances the distribution of Y0 and Y1 with respect to D. It is often dicult in practice to match on high dimensional X. However RRs result allows us to perform matching based on P(X) alone. This insight reduces a potentially high dimensional matching problem to a one dimensional matching problem provided that P(X) is known. P(X) is also termed as the propensity score. Heckman, Ichimura and Todd (1998) extend this result by developing an asymptotic distribution theory for kernel based matching estimators. Further they demonstrate that (A-1) and (A-2) called the strong ignorability conditions in the literature are overly strong for the estimation of (P-1) and all that is required is a weaker mean independence version E (Y0 | D = 1, P (X )) = E (Y0 | D = 0, P (X )) Mean Independence conditions are routinely invoked in the econometrics literature22 7.1.1 Alternative Matching Estimators

Many matching methods are presented in the published literature. All estimators are special cases of the following formula

(S ) = M
i I1

wN0 ,N1 (i)[Y1i


j I0

WN0 ,N1 (i, j )Y0j ],

f or

X S

where N1 and N0 are the number of observations in the treatment and control groups, wN0 ,N1 (i) is a weight accounting for heteroscedasticity, WN0 ,N1 (i, j ) is a weight with WN0 ,N1 (i, j ) = 1. I1 and I0 are indices for the treatment and control groups respectively, S is the subset of common (S ) is the mean eect of interest. Alternative matching estimators support for the two groups and M dier in the weights attached to members of the control group. The following matching procedures are employed in this paper. (All of these procedures are discussed in detail by Heckman, Ichimura and Todd(1997,98) and related references therein) Simple Propensity Score Nearest Neighbor Matching Match using the n neighbors with the closest propensity scores. n = 1 denes the nearest neighbor matching which is the conventional estimator Simple Propensity Score Matching within Propensity Score Calipers First, I restrict the set of possible matches to observations with propensity scores within a specied range (called the caliper width), and then within this range, chose the observation closest in terms of the
22

j I0

See, for example, Barnow,Cain and Goldberger(1980) or Heckman and Robb(1986)

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 propensity score as the match. I consider n = 10 as the number of nearest neighbors in the estimation Kernel Matching The kernel based matching estimators construct matches by weighted averages over the outcomes of multiple observations in the D = 0 comparison sample. If weights from a typical symmetric, non negative, unimodal kernel are used, then the average places higher weight on persons close in terms of Xj and lower or zero weight on more distant observations. Two types of kernels are considered - the standard Gaussian kernel and the Epanechnikov kernel (this means that only observations that fall within a radius of the bandwidth specied is used to construct the weighted match) Local Linear Least Squares Smoothing Matching This method is similar to kernel matching in its averaging, except with dierent weights23 . Local linear weights instead of conventional kernel weights are used because local linear estimators converge at a faster rate at boundary points and adapt better to dierent data design densities. Regression Adjusted Local Linear Matching This method combines local linear matching on the propensity score and regression adjustment on the X and uses the following procedure. Assume a conventional conventional econometric model for outcomes in the control group that is additively separable in observables and unobservables Y0 = X0 + U0 Using partial regression methods applied to the comparison group sample, estimate the components of E (Y0 | D = 0, X ) = X0 + E (U0 | D = 0, X ) 0 from Y0 alone or from both Y0 and Y1 and apply To estimate the treatment eect, remove X the general estimator formula described in the beginning of the section on the residuals. The standard errors for the mean eect of interest, the bond bank spread for all these matching methods is obtained by bootstrapping based on 50 replications with 100% sampling.

7.2

Adjustment for Collateral Dierences between Bank Loans and Bonds

All observations in the sample except that of C3 have the feature that bank loans are collateralized while bonds are not. Thus any computation of spreads has to make an explicit adjustment for this factor before applying the econometric methodology described in the earlier section. I attempt to get at this issue by assembling a secondary data set of yields of collateralized and uncollateralized bank loans of the same rm at the same point in time matched by credit rating.24 The yield
See, Heckman, Ichimura, Todd(1997) Construction of such a sample is important for 2 reasons. Banking literature (Berger and Udell (1990)) has documented a positive relationship between collateral and risk. Collateralized loans in general have higher yields
24 23

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 dierence between these two types of loans is then used as the adjustment for collateral in samples C1,C2 and C4 while computing the Bond-Bank spread. Alternatively I measure the dierences in the yield of secured and unsecured loans, after controlling for other factors by estimating the following Ordinary Least Squares (OLS) regression: Y ieldi = 0 + 1 DealSizei + 2 M aturityi + 3 Securedi + 4 (AGrade)i + 5 (BBBGrade)i + 6 (BelowInv.Grade)i + 7 Adequacyi + 8 Libor + 9 T ermP remium + 10 InterestRateV olatility + i The impact of Collateral is measured by the size and signicance of the coecient of the Secured dummy variable. By interacting this dummy with dummies for various credit classes, the impact of collateral by credit classes can be ascertained.

7.3

Mean and Median Spread Dierences, Collateral Adjustment

Table 2 provides the results of the bank bond spread computed by credit classes. Panel A shows the number of observations in the sample cross tabulated by the bank loan and bond rating. As seen, there are 7,426 total observations (excluding the not rated observations) in the sample. Out of these 5,652 observations are exactly matched by broad credit rating class which is about 76% of the sample. Panel B summarizes the mean Bond Bank spread in a cross table. Of particular interest are the entries on the diagonal of the table. For the top credit classes (AAA, AA and A) the spread is negative, while it is positive for the rest of the credit classes. The maximum spread is about 158.54 basis points for the B rated credit class and it drops to 38.92 basis points for the CCC rated borrowers. Since Panel Bs mean spreads might be driven by a few outliers, Panel C computes the median spreads across credit classes. It can be seen that the median spreads are quite close to zero for the top credit classes (3.05, -1.67 and -9.89 basis points respectively for AAA, AA and A rated borrowers respectively). For the BBB and BB borrowers the spreads are positive and about the same at 16 basis points. The spreads are the highest for B rated borrowers at 100 basis points which drops 16.37 basis points for the CCC rated borrowers. As can be seen from the table and gure, the bond bank spread is close to zero for the high credits and positive for the middle and low rated credits. This is consistent with the predictions of the theoretical model and also with a view that banks do not add much value to the high quality borrowers who have easy access to the bond markets while the borrowers in the middle of the credit spectrum are benetted most by a bank relationship. However, the results presented above however do not adjust for collateral dierences between
than uncollateralized loans. A similar nding has been documented for bonds by John, Lynch and Puri(2000). Using the same rms secured and unsecured loans eliminates the rm risk factor that can cause yield dierences. Secondly since samples C1 to C4 have a large number of ratings matched observations, a ratings matched yield adjustment for collateral is desirable. The constructed sample addresses both these concerns

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 bank loans and bonds. All bank loans in Table 2 are collateralized while all bonds are not. To ensure that dierences in collateral are not driving the result, I employ 2 measures. First, I construct a clean sample of bank loans and bonds where both are not collateralized and matched by Credit Rating, Seniority and Maturity as closely as possible. Next, I make an explicit basis points adjustment for collateral dierences as detailed earlier. Table 3 provides the results of the bank bond spread computed by credit classes for this clean sample. Panel A shows the number of observations in the sample cross tabulated by the bank loan and bond rating. As seen, there are 145 total observations (excluding the not rated observations) in the sample. Out of these 130 observations are exactly matched by broad credit rating class which is about 90% of the sample. Panel B summarizes the mean Bond Bank spread in a cross table. Of particular interest again are the entries on the diagonal of the table. For all the credit classes the spread is uniformly positive and monotonically increasing. The maximum spread is about 191.22 basis points for the B rated credit class and the minimum spread is 6.75 basis points for the AAA rated borrowers. Since Panel Bs mean spreads might be driven by a few outliers, Panel C computes the median spreads across credit classes. It can be seen that the median spreads follow the same pattern as that of the mean spreads. Figure 5 shows the mean and median spreads across the credit spectrum for the ratings matched sample where these trends are readily apparent. This evidence can again be interpreted as the value of banks increasing across the credit spectrum. This is despite the presence of potentially osetting costs such as monitoring costs and bank regulatory taxes for banks compared to that of bonds. It also implies that agency costs are higher for lower rated borrowers. Table 4 reports the results of the collateral adjustment method described above. Panel A provides the dierences between yields of Unsecured and Secured Bank Loans by credit classes. As can be seen from the table, on the margin, collateral does not make a big dierence in pricing of bank loans. The dierence is about 5 basis points for the top rated borrowers (AAA,AA,A), 17 basis points for BBB rated rms and 33 basis points for below investment grade borrowers. Panel B attempts a regression framework to explicitly control for contract dierences between unsecured and secured loans as well as market conditions. The coecients on the interaction term between the credit rating dummy and the secured dummy provided the necessary adjustment. As can be seen the coecients are negative as expected and virtually identical in magnitude to that of Panel A. These adjustment factors are used to adjust the numbers in Table 2 for collateral. The collateral adjusted numbers for the ratings matched sample is then used as inputs for the econometric methodology on matching described above. Table 5 presents the results of the matching estimators. The results using all the seven dierent methods (Panels A-G) are very similar and conrms the predictions of the model in a rigorous way. The Bond - Bank Spread is about -6 basis points for AAA,AA rated borrowers, -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 points for the B and CCC rated borrowers respectively. Thus agency costs or value addition by banks seem to be important for BBB and below investment grade rms across the credit spectrum (The numbers reported are the average of the 7 dierent methods). All Bank Bond spreads except for the AA rated class are statistically dierent from 0 at the 0.5% level of signicance. Figure 6 shows the mean value of the spreads for the 7 dierent methods across the credit spectrum for the ratings matched sample.25

7.4

Possibility of mispricing by banks

It is quite possible that the spread between bonds and bank loans uncovered in this paper could be attributed to mispricing by banks and not related to the any of the economic issues discussed above. Indeed, a view among the market participants is that interest rate spreads on high risk loans have been too low on average, whereas those on low-risk loans have been adequate (Miller (1993)). Some claim there is great variation of spreads on otherwise similar individual loans, or insucient variation across loans posing dierent levels of risk. To guard against this possibility, I compute the median Return on Equity (ROE) for commercial banking operations, of all US banks (excluding investment banking and other businesses as there could be cross subsidization) during 1996-2000. This period was chosen to coincide with the period of coverage of the data on yields. As can be seen from gure 7, US banks consistently earned a ROE greater than than the cost of equity (computed for 159 US banking rms) during the entire period. Further Carey (1995) concludes based on the evidence that it is not possible to reject the notion of market eciency in the bank loan pricing market and that bank loans are not likely to be mispriced. Taken together, it is reasonable to conclude that the spreads documented in this paper are not driven due to mispricing by banks.

Conclusion

This paper proposes a model of debt choice with rm moral hazard and bank holdup. It emphasizes that a rms desire for nancial exibility leads to co existence of relationship debt (bank loans) and uninformed debt (bonds)in its capital structure. Banks are benecial because they are able to monitor and check risky asset substitution activities of the rm. Banks by virtue of their access to information, however hold up the rm ex-post to extract rents after projects are in place. Uninformed lenders such as the bond markets can be used by the rm to limit the costs of bank nancing while the rm continues to enjoy the relationship benets of bank nancing. Optimal trade o of these eects results in coexistence of bank loans and bonds. Contrary to common concerns, bank
Results for AAA are not available as the matching methods rely on a common support for the loans and bonds, which is not satised in this credit class and hence the raw data excluding 1 outlier is presented
25

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 oversight increases in the presence of bonds. It is also shown that multiple banking relationships are not as eective as bond markets to satisfy the rms need for nancial exibility. A number of empirical implications are also generated by the model, testing of which is left for future research. The object of immediate testable empirical interest from the model is the Bond-Bank spread. The spread is computed for two cases : (i) Bank loans senior to bonds and (ii) Banks and Bonds have equal seniority. In the case when bank loans are senior to bonds, the Bond-Bank spread is shown to be positive despite osetting costs of bank nance, namely costly monitoring. The benet of seniority to the bank is sucient to overcome the monitoring costs, thus enabling the bank to seek a lower promised yield. With equal seniority, the paper shows that for High Quality Firms, above a certain threshold (proxied for in the model by how often the good project outcome is likely to be realized), the Bond-Bank spread is negative. This is because, for the rm, the benets of bank monitoring are outweighed by the costs of bank hold up causing the spread to be negative. For rms below this threshold or Low Quality Firms, the opposite is true, causing the spread to be positive. This is the implication that is tested empirically, with credit rating used as the proxy for rm quality. The empirical study uses matching which is a widely-used method of evaluation. Sample selection criteria is thus used as a principal method for achieving comparability and appropriateness. The paper uses a large and unique, carefully constructed data set from multiple data sources of Bond and Bank yields for the same rm at the same point in time, matched by Credit Rating, Seniority, Maturity and adjusted for collateral dierences. It is then shown that the Bond Bank Spread is negative for high credit quality rms and positive for low credit quality rms, consistent with the theoretical model. Applying a new econometric methodology developed by Heckman et al(1998), that views matching of Bonds and Bank loans as an econometric evaluation estimator, the results of the sample are conrmed rigorously. The Bond - Bank Spread is about -6 basis points for AAA,AA rated borrowers, -76 basis points for A borrowers, 75 and 53 basis points for BBB and BB borrowers, increasing to 173 and 335 basis points for the B and CCC rated borrowers respectively. Thus agency costs or value addition by banks seem to be important for BBB and below investment grade rms across the credit spectrum. The task of nding variables that can explain cross sectional variations in these spreads is left for future research.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

Appendix

Proof of Lemma 1 The rms maximization problem is max m , D02m m (G D02m ) + (1 m )( (B D02m ) + (1 )0) conj conj )(D02m + (1 ).0) I (IR) and D02m + (1 m s.t. m conj m = m . (Rational Expectations) The foc of this problem wrt D02m yields (m + (1 m ) )(1 + ) = 0 where is the multiplier on the IR constraint. This implies = 1 indicating that the individual rationality constraint for the lender is binding. I Since (G D02m ) (B D02m ) the rm chooses m = 0 to maximize its payo. This means D02m = I to satisfy the IR constraint. At this value the rm payo = (B ) = B I < 0, which implies m = 0 is not optimal. The lowest value of D02m = I is when m = 1. But having obtained the loan, the rm can deviate all the way to m = 0 to maximize its payo. Thus m = 1 is not optimal as well. The problem stems from the the inability of the rm to pre commit to a m ,as ex-post deviation from this m towards 0 is always optimal for the rm at the expense of the bond holder. Thus there is no sustainable equilibrium. Proof of Lemma 2 1. The payo for the rm for any 1 [0, min ) is dominated by the choice of any 2 [min , max ). To see this compute X(2 ) - X(1 )=(2 1 ) k (G L) + (1 )(2 (G D01b ) + (1 2 ) (B D01b )) Since the second term is positive and 2 > 1 the RHS is positive for 2 , 1 2. The payo for the rm for 2 = max dominates all 1 [min , max ). Consider X(max ) -X(1 ) = (max 1 ) k (G L)+ (1 )[(max 1 )(G B ) + P (1 )D01b P (max )D01b ]. Since P(max )D01b = L and P (1 )D01b L and max > 1 , RHS is > 0. Thus max dominates all 1 [min , max ). 3. Consider [c , 1]. X () = (1 )[(G B ) (1 )D01b ] + [k (G L) k (L B ) (B D01b )] (1 )[(G B ) (1 )D01b ] + [(G D01b ) k (L B ) (B D01b )] = [(G B ) (1 )D01b ] k (L B ) < 0 The inequality comes from the fact that k (G L) (G D01b ) (i.e) the pay o to the rm when held up is lower than the payo when not held up by the bank. The last line follows from the fact that (G D01b ) (B D01b ). This implies that X () is decreasing in . Thus X () is maximum at = c if [c , 1]. Using (1), (2) and (3) it follows that optimum [max , c ].

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45


Proof of Proposition 1 Using the results of Lemma 1, I consider the case of and show that this is an equilibrium. [max , c ) and obtain a solution for and

The payo for the bank in this range is Y (, ) = (L + (1 k )(G L) c P ()D01b ) + P ()D01b = [V M []] + P ()D01b where VM[] is the value to monitoring function. The payo for the rm in this range is X (, ) = [k (G L) + (1 )((G B ) (1 )D01b )] + (1 ) (B D01b ) = [RRS []] + (1 ) (B D01b ) where RRS[] is the returns to risk shifting function. V M [] and RRS [] are the marginal benets of monitoring and the manufacturing policy respectively. Note that V M [] is decreasing in for [max , c ) and RRS [] is increasing in for [0, 1]. Further V M [max ] > 0 and RRS [0] < 0. Let and be the values of and such that, V M [ ] = 0 and RRS [ ] = 0. The best responses for the rm () and the bank () can be characterized as under : () = ( max : 0 < , c ) : = c : 1 max < = < < c

max

1 : () = (0, 1) : 0 :

Setting V M [] = 0 and RRS [] = 0 we obtain and L c D01 b and V M [] = 0 yields = (1 )D01b (1 k )(G L) RRS [] = 0 yields =
max
(1 )D01 b (GB ) (GB ) k(GL)+(1 )D01 b

along with the lender rationality condition P( )D01 b = I yields the expression in the text. Using P( )D01b = L and the expression for , I obtain

max =

(I L) ( I

1 )

<

Consider now the case of c . Can the borrower choose = c ? The payo to the rm at = c , X (c , ) = [c k (G L) + (1 c )( (B D01b ) + k (L B )) c G (1 c )B + P (c )D01b ] + (c G + (1 c )B P (c )D01b ) and RRS [] = [k (G L) (B D01b ) k (L B )] + (1 )[G B (1 )D01b ]

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46


The payo to the bank at = c , Y (c , ) = [c (L + (1 k )(G L)) + (1 c )(D01b + (1 k )(L B )) P (c )D01b c] + P (c )D01b and V M [c ] = c (G D01b k (G L)) + (1 c )(1 k )(L B ) c Case (a) V M [c ] < 0 Assume that the borrower chooses c . In this case, the best response (c ) of the bank = 0 which leads to (0) = max , thus unravelling the response = c . Thus no equilibrium exists in this case. Case (b) V M [c ] > 0 Assume that the borrower chooses c . Consider Y ( , ) Y (c , ) = I [ V M (c ) + P (c )D01b ] = V M (c ) < 0. Thus ( , ) dominates (c , ) for the bank. In this case the payo of the bank = V M (c ) + P (c )D01b . Lender rationality implies P (c )D01b = I in a competitive credit market which implies = 0 is the best response of the bank. Since V M [c ] > 0 and the payo cant exceed I, this would imply the best response of the rm to be max rather than c , thus unravelling the equilibrium. Further, from the view point of the lender this can be seen clearly, by considering Y ( , ) Y (c , ) = I [ V M (c ) + P (c )D01b ] = V M (c ). If V M [c ] > 0 , the lender can ensure indierence between the payos by setting = 0. A competitive credit market does not place any value on the monitoring services of the bank, if the rm complies with its covenants. As we have seen (c , 0) is not an equilibrium. Now consider Y (c , ) Y ((c ) , ) = (1 c )( (B D) + k (L B )) (neglecting the following terms as they are 0 = (1 )[P (c ) P ((c ) )]D01b + [(c ) (c ) ](1 k )(G L)) To ensure that the rm complies with its covenants and at the same time give it (the bank) the control rights when a bad project is realized, is not possible for the bank. It has to oer a part of the surplus (L B )( which is greater than (B D01b )) to the rm to induce it to voluntarily liquidate. To minimize this occurrence, the bank sets the strictest covenant, c = 1 and this also maximizes its incentive to monitor. This also implies that V M [c = 0 in general as it leads to the relationship G D01b k (G L) c = 0 D01b c satised on only at a special value of k = G (GL) . This case is not considered further in the analysis. Proof of Proposition 2
I +cL) From equation 3 of Proposition 1, = (1( 1, I obtain k = k)(GL) . Since automatically satised. I (1k)(GL) From equation 2 of Proposition 1, D01 b = (I +cL)(1 )+ (1k)(GL) G(I +c) (GL) .

1 is

(I +cL)(1 )G Since D01 b G , I obtain k = 1 (GL)(I G) . Since k cannot be less than 0, I obtain the expression in the text. Dene kcrit as the value of k, which satises kcrit = G D01 b . Substituting for D01b from equation 2 of < k) Proposition 1, solving the quadratic equation in kcrit and taking the positive root (as k < kcrit I +L2 IL yields the expression for kcrit in the text. A sucient condition for kcrit to be real is c < , (1 ) which I assume, to hold. To solve for k + consider the inequality of hold up discussed in the text k (G L) (G D01b ). The lower bound on D01b = I , determines the upper bound on k beyond which it is not economical for the bank to hold up (see the discussion before Lemma 3 in the text). This yields the expression for k + .

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47


Proof of Proposition 3 From equation 3 of Proposition 1, I obtain From equation 2 of Proposition 1, Note =
f D01 b 1 ) f (k,D01 b
D01 b k

(I +cL) (1k2 )(GL)

> 0 < 0
D01 f b D01 k b

I (I +cL)(GL)(1 ) ((I +cL)(1 )+ (1k)(GL))2 Then, 1 = 2 k

= [

(1D01 b )(GB ) 1 ] . k(GL)

f k

k(GL)(1 ) (GB )]2 [(1 )D01 b

< 0;
k

f k

(GL) ] [(GB )(1 )D01 b

> 0
1 P ( ) 1

Using the above inequalities implies


rbank k

< 0 . From Corollary 1, the price of bank loan = rbank =

1 [P ( )]2 (1

< 0
k c

Using the expression for the critical cutos from proposition 2,


k c

(1 )G (GL)(I G)

< 0

1 (GL)

< 0;

kcrit c

(1 )

1 c

2(GL)

> 0 , since

= 2(1 )[(1 )c I L] < 0.

Proof of Proposition 4 Using arguments similar to Proposition 1,


V M [ ] = 0 yields (L + (1 k )(G L) D01 b ) + (1 )(L D01b ) c = 0 RRS [ ] = 0 yields k (G L) + (1 )(G D01 b ) D02a (1 ) (B D01b D02a ) = 0

Individual rationality conditions for the bond market and bank loans yields
D02 a + (1 )(1 ) D02a = (1 s ) I

and

[ (L + (1 k )(G L)) + (1 )D01 b ] + (1 )[ L + (1 )D01b ] c = s I

Finally, the rm chooses its bank debt such that its net marginal benet from bank debt is zero (i.e.) dX (D01 b) = 0 . This yields dD
01b

(1 )( + (1 ) ) = 0. Solving these equations simultaneously and noting that + (1 ) = 0 yields the expressions in the text.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48


Proof of Lemma 4
02a 01b the Bond Bank Spread = (1s D02 from Proposition 4 and ) I s I . Substituting for a , D01b , s simplifying yields the expression in the text. c L
1 ( I +c L + GI c (I +cL)2 1 ( ) + 1

= =

1 I c 1 (G I +cL )( )( GL ) 2 ( ( 1 ) + 1)

+cL < 0, where = ( IG L )

I c 2 (G I +cL ) 1 ( ) +

I c 1 GI c (G I +cL )( )( (GL)2 ) 2 ( ( 1 ) + 1)

> 0.

Proof of Proposition 6
01b Each Banks individual lender rationality condition is [ (1 ) + ] 2 = I 2 which gives equation 3 of the proposition. The optimal monitoring policy of either bank leads to the net marginal benet of monitoring V M [ ] , the coecient of in Y1 (, ) or Y2 (, ) to be zero - this yields equation 1. The optimal manufacturing policy of the rm leads to the net marginal benet of risk shifting RRS [ ] ,the coecient of in X (, ) to be zero. This yields equation 2 of the proposition.

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Figure 1 Size of Debt Markets The top panel provides data on corporate new issuance of equity and debt in 1997. The bottom panel provides the composition of the capital stock of equity (in market value terms), bank loans and bonds for all US corporations in 1990, 1995 and 1999.

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Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Figure 2 Time Line of Events

<

<

<

<

(G

I)

<

(B

I)

``` -I ``` ``` ```

```

B ``` ``` ``` ` 1 0

t=0 rm: chooses invests I

t=1

t=2

realizes project type

payos

Bank: chooses monitoring intensity realizes project type w.p

Information: , private c - unit cost of monitoring k - bargaining power of the rm public

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Figure 3 Patterns of Bank Borrowing This gure provides the optimal manufacturing policy of the rm , the optimal monitoring intensity of the bank and the probability of repayment P () as a function of the bargaining power of the rm k. The parameters of the model are set at L = 1.8, I = 2.0, G =2.5, B = 3.5, = 0.4 and c = 0.2.

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Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Figure 4 Patterns of Bank Borrowing due to an increase in monitoring costs

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Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Figure 4b Behavior of the Bond-Bank Spread

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Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Figure 5 Bond Bank Spread Across Credit Classes - Clean Sample This gure provides estimates of the Bond Bank spread in basis points dened as the yield dierential between Bond and Bank Loans. For each Bank Loan with yield over LIBOR information, a Bond of the same rm at the same point in time is chosen as a match and its yield obtained. The Bond has the same seniority as the bank loan, and matched as closely as possible on maturity outstanding and the credit rating of the loan. A treasury with the same maturity as that of the bond is used as the reference to compute the bond spread over treasuries.Linear interpolation is used in case exact maturity match is not found.All Bank Loans and Bonds in the sample are not collateralized.

Bond-Bank Spread (mean)

190.00

140.00 basis points

90.00

40.00

-10.00

AAA

AA

BBB

BB

Credit Class of Bank Loan and Bond Collateral Matched Sample

Bond-Bank Spread (median)

190.00

140.00 basis points

90.00

40.00

-10.00

AAA

AA

BBB

BB

Credit Class of Bank Loan and Bond Collateral Matched Sample

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Figure 6 Bond Bank Spread Across Credit Classes using Matching Estimators This gure provides estimates of the Bond Bank spread in basis points dened as the yield dierential between Bond and Bank Loans. For each Bank Loan with yield over LIBOR information, a Bond of the same rm at the same point in time is chosen as a match and its yield obtained. The Bond has the same seniority as the bank loan, and matched as closely as possible on maturity outstanding and the credit rating of the loan. A treasury with the same maturity as that of the bond is used as the reference to compute the bond spread over treasuries.Linear interpolation is used in case exact maturity match is not found.All Bank Loans in the sample are collateralized while all Bonds are not. Collateral adjusted yields are obtained as described in Table 4. The spread is estimated as the mean of the 7 matching estimators presented in table 5.

 !"$#%& '(!$)01& '!%$)2& !$)34%5 FFB37 6H R S Q S$T Q S$S Q x y UVT Q UVS Q T Q S Q I R$Q I P$Q WWW WW W XXX XX X Y`Y`Y abc$de fAag h$i$iqprshtuqvphtwhtd!sptd 687 69 G D87 FH G @D37 CAF @937 9A@ BC37 BAD E@F37 98E

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Figure 7 Return on This gure for all US tions (bank

Equity of Commercial Banking Operations of US Banks 1996 - 2000 provides estimates of the median return on equity (ROE) in percentage points banks for the years 1996-2000. Data covers only commercial banking operalending) of the banks in the sample. Banks are classied based on asset size.

 "!$#%'& ()102345#6#") 7' ()8'9@(1ABC)DFEHG')$(I 'P%1QR9@()5ASP TVUBUBWB2$XBYYBY WBYBt w'YBt v'YBt uBYBt XBYBt TIYBt YBt `hehc `h`hc UBt ih`hc adrhc egfc ad`hc hhb f eh@B S 1 hVg `hehc frhc 'gbdfeSgShSig j TIUBUW f`hc hhb 4f@B S adshc ebadc `h`hc `hihc fphc hhb @eh@B S fqhc adshc adehc ehehc `badc ih`hc

X YBYBY B TIUUBU TIUBUBx TVUBUBy kISiglCmhngoggpgjgq @Igh rkIjb hstidu fS`hhgfvt1w@'gs4xgid bu S yBz{|dz}~h | 1zh| h ~} zh6Ihzhh h {'1~h{h | ~ BB {| ~h ~ hhzhh

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Table 1 Panel A : Data Sources Used in the Study Sample C1 C2 C4 C3 Total Loan Information Gold Sheets/Dealscan Gold Sheets/Dealscan Deal Scan Deal Scan Bond Information Gold Sheets Yield Book FISD/Yield Book FISD/Yield Book observations 3900 3107 486 147 7640

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Table 2 Bond Bank Spread Across Credit Classes This table provides estimates of the Bond Bank spread in basis points dened as the yield dierential between Bond and Bank Loans. For each Bank Loan with yield over LIBOR information, a Bond of the same rm at the same point in time is chosen as a match and its yield obtained. The Bond has the same seniority as the bank loan, and matched as closely as possible on maturity outstanding and the credit rating of the loan. A treasury with the same maturity as that of the bond at the same point in time is used as the reference to compute the bond spread over treasuries. A swap spread for the corresponding maturity is subtracted from the bond spread to obtain the spread on a oating rate basis. Linear interpolation is used in case exact maturity match is not found. Sample excludes 67 observations where the bond is not rated. All Bank Loans in the sample are collateralized while all Bonds are not. Panel A: Number of Observations Rating AAA AAA 17 AA 1 A Loan BBB Rating BB B CCC D AA 1 17

Bond Rating A BBB 1 1 1 174 31 3 239 16 8 1

BB

CCC

30 812 1

1 1248 4261

421 130 2

Panel B: Mean Bond Bank Spread in Basis Points Bond Rating Rating AAA AA A BBB BB AAA -22.38 -3.49 1.67 15.03 AA -51.75 -18.43 5.04 A -80.86 10.43 Loan BBB -144.22 26.23 265.08 Rating BB 25.87 26.00 B 33.74 5.77 171.38 CCC D Panel C : Median Bond Bank Spread in Basis Points Bond Rating Rating AAA AA A BBB BB AAA 3.05 -3.49 1.67 15.03 AA -51.75 -1.67 5.04 A -9.89 16.97 Loan BBB -141.15 16.34 56.83 Rating BB 4.95 16.69 B 15.84 5.77 171.38 CCC D

CCC

400.41 164.65 158.54

815.48 38.92 3159.25

CCC

400.41 110.97 100.02

608.67 16.37 3159.25

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Table 3 Bond Bank Spread Across Credit Classes - Clean Sample This table provides estimates of the Bond Bank spread in basis points dened as the yield dierential between Bond and Bank Loans. For each Bank Loan with yield over LIBOR information, a Bond of the same rm at the same point in time is chosen as a match and its yield obtained. The Bond has the same seniority as the bank loan, and matched as closely as possible on maturity outstanding and the credit rating of the loan. A treasury with the same maturity as that of the bond at the same point in time is used as the reference to compute the bond spread over treasuries. A swap spread for the corresponding maturity is subtracted from the bond spread to obtain the spread on a oating rate basis. Linear interpolation is used in case exact maturity match is not found. Sample excludes 4 observations where the bank loan is not rated. All Bank Loans and Bonds in the sample are not collateralized.

Panel A: Number of Observations Bond Rating Rating AAA AA A AAA 2 AA 7 Loan A 33 Rating BBB 2 BB B

BBB 1 3 77 3 1

BB

11 1

Panel B: Mean Bond Bank Spread in Basis Points Bond Rating Rating AAA AA A BBB BB B AAA 6.75 AA 8.09 Loan A 25.26 55.69 Rating BBB 22.99 26.13 BB -79.89 95.66 B -24.61 163.68 191.22

Panel C : Median Bond Bank Spread in Bond Rating Rating AAA AA A AAA 6.75 AA 21.03 Loan A 18.68 Rating BBB 22.99 BB B

Basis Points BBB 195.79 55.69 25.75 -196.25 -24.61 BB B

59.08 163.68

191.22

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

Table 4 Adjustment for Bank Loan Collateral in Basis Points This table provides estimates of the value of collateral in basis points dened as the average yield dierential between Unsecured and Secured Bank Loans for the same rm at the same point in time and where both loans are matched by credit rating. Panel A provides the mean and median dierences. In Panel B, the dependent variable for the regression in the Bank Loan Yield over LIBOR expressed in basis points. Standard errors are reported in parentheses. Panel A: Spread Dierence in Basis Points between Secured and Unsecured Loans Rating AAA,AA,A BBB Below BBB Total Obs 13 13 57 83 Yld (Secured) 116.73 148.62 222.81 194.57 Yld (Unsecured) 121.38 165.73 256.22 220.93 Di (Unsecured-Secured) 4.65 17.12 33.41 26.35 Median Di 0.00 0.00 0.00 0.00

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

Table 4 (continued) Panel B: Eect of Collateral on Basis Points Variable Facility Size/Deal Size Facility Size Deal Size Maturity Secured A Grade BBB Grade Below Investment Grade Adequacy Libor Term Premium Interest Rate Volatility A Grade * Secured BBB Grade * Secured Below Inv. Grade * Secured Number of Observations Adjusted R-Squared 166 0.263 -0.07 (0.3) -24.32 (14.73) 68.56 (121.49) 111.14 (122.85) 187.20 (121.99) -32.27 (35.11) 9.27 (13.37) -1.61 (21.02) 166.06 (61.71) -0.06 (0.3) 55.91 (123.2) 109.21 (124.62) 190.43 (122.64) -32.31 (35.26) 9.30 (13.43) -1.54 (21.12) 166.10 (61.99) 1.06 (37.27) -20.49 (37.28) -30.98 (17.83) 166 0.256 0.05 (0.29) -26.64 (14.88) 42.33 (122.8) 83.70 (123.99) 166.33 (123.44) -32.38 (35.66) 8.13 (13.53) -5.21 (21.26) 168.01 (62.52) 0.05 (0.3) 31.16 (124.7) 78.93 (125.65) 169.54 (124.13) -32.36 (35.83) 8.14 (13.59) -5.18 (21.36) 168.07 (62.82) -4.87 (37.66) -17.67 (37.74) -33.66 (18.01) 166 0.237 I -54.56 (27.02) II -55.11 (27.24) III IV V VI

-5.31E-09 (2.28E-08)

-5.37E-09 (2.29E-08) -5.37E-09 (1.47E-08) 0.06 (0.29) -26.63 (14.87) 43.90 (122.75) 84.93 (123.91) 167.97 (123.47) -32.53 (35.61) 8.12 (13.52) -5.46 (21.27) 166.81 (62.64) -5.05E-09 (1.48E-08) 0.06 (0.3) 32.76 (124.68) 80.05 (125.57) 171.06 (124.16) -32.50 (35.78) 8.12 (13.59) -5.41 (21.37) 166.94 (62.94) -5.11 (37.67) -17.60 (37.73) -33.60 (18.01) 166 0.237

166 0.244

166 0.244

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

Table 5 Estimated Bond Bank Spread - Matching as an Econometric Evaluation Estimator This table provides estimates of the value of the Bank Bond Spread in basis points dened as the yield dierential between Bond and Bank Loans. The rst column in each of the panel is the credit rating of the Bond and the Bank Loan. The second column estimates the mean Bond Bank Spread by the matching estimator outlined in the panel. Standard Errors for the estimator is in the third column. Standard errors are obtained by bootstrapping based on 50 replications with 100% sampling. The fourth and fth column estimates the Bias in using the estimator, as dened in the text. The last column provides a 95% Bias Corrected Condence Interval for the Bank Bond spread. Negative numbers are within parentheses. Panel A provides the Simple Propensity Score Nearest Neighbor Matching Estimator. Panel B details the Simple Propensity Score Matching within Propensity Score Calipers. In Panel C and D, the results from Kernel Based Matching Estimators are presented. Panel C uses a Gaussian Kernel and Panel D an Epanechnikov Kernel. Trimming rules for common support and bandwidth for kernel estimators follow recommendations from Heckman et al (1998). Panel A: Simple Propensity Score Nearest Neighbor Matching Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (15.09) (76.29) 73.52 50.69 158.75 335.75 Standard Error Basis Points 23.57 10.91 16.26 7.23 6.10 27.11 Bias Bias (%) 95% Condence Interval [-60.50, 14.40] [-97.93, -52.34] [47.64, 113.28] [38.77, 65.86] [150.06, 171.63] [296.42, 426.93]

2.39 (1.31) 0.53 (1.07) 0.05 (4.08)

-15.83% 1.71% 0.72% -2.11% 0.03% -1.22%

Panel B: Simple Propensity Score Matching within Propensity Score Calipers Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points 10.61 (68.02) 75.12 50.02 175.13 346.41 Standard Error Basis Points 17.01 15.43 16.55 8.39 6.04 27.50 Bias Bias (%) 95% Condence Interval [-1.35, 22.18] [-87.33, -42.01] [43.74, 97.66] [35.85, 68.18] [165.10, 188.60] [299.93, 393.26]

(10.53) (6.52) (5.53) 0.32 (0.20) 6.53

-99.18% 9.59% -7.36% 0.65% -0.12% 1.88%

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Table 5 (continued) Panel C: Kernel Based Matching Estimator (Gaussian Kernel) Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (1.05) (81.36) 74.31 51.86 172.85 336.99 Standard Error Basis Points 11.19 14.21 13.20 7.76 5.18 20.31 Bias Bias (%) 95% Condence Interval [-34.71, 13.51] [-101.25, -42.99] [45.23, 96.68] [40.94, 78.52] [163.86, 182.90] [306.88, 388.99]

1.56 (1.42) 0.53 0.08 0.40 (6.06)

-148.76% 1.74% 0.72% 0.15% 0.23% -1.80%

Panel D: Kernel Based Matching Estimator (Epanechnikov Kernel) Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (6.08) (76.89) 81.29 49.44 173.93 343.90 Standard Error Basis Points 14.39 14.44 14.33 10.72 6.23 28.09 Bias Bias (%) 0.95 Condence Interval [-53.51, 16.69] [-107.60, -49.81] [48.98, 108.82] [31.43, 65.83] [166.26, 192.50] [300.29, 419.63]

6.51 (3.69) 2.16 1.49 (1.40) 0.49

-106.99% 4.79% 2.65% 3.01% -0.81% 0.14%

Panel E: Local Linear Least Squares Smoothing Matching Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (16.01) (78.24) 56.43 52.94 175.13 335.64 Standard Error Basis Points 18.51 14.14 15.24 6.84 5.35 20.75 Bias Bias (%) 0.95 Condence Interval [-49.87, 8.99] [-106.79, -51.05] [19.36, 77.94] [43.92, 65.01] [165.88, 184.87] [308.28, 380.70]

10.62 (2.61) 2.83 (0.50) (0.71) 2.35

-66.36% 3.34% 5.02% -0.95% -0.40% 0.70%

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

Table 5 (continued) Estimated Bond Bank Spread - Matching as an Econometric Evaluation Estimator This table provides estimates of the value of the Bank Bond Spread in basis points dened as the yield dierential between Bond and Bank Loans. The rst column in each of the panel is the credit rating of the Bond and the Bank Loan. The second column estimates the mean Bond Bank Spread by the matching estimator outlined in the panel. Standard Errors for the estimator is in the third column. Standard errors are obtained by bootstrapping based on 50 replications with 100% sampling. The fourth and fth column estimates the Bias in using the estimator, as dened in the text. The last column provides a 95% Bias Corrected Condence Interval for the Bank Bond spread. Negative numbers are within parentheses. Panel E provides the Local Linear Least Squares Smoothing Matching Estimator. In Panels F and G, the results from Regression Adjusted Local Linear Matching Estimators are presented. Panel F uses the adjustment on controls only and Panel G on both controls and the treated. Trimming rules for common support and bandwidth for kernel estimators follow recommendations from Heckman et al (1998). Panel F: Regression Adjusted Local Linear Matching on Controls Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (8.35) (74.81) 85.77 52.37 176.09 337.02 Standard Error Basis Points 20.96 12.89 17.70 7.21 6.48 21.79 Bias Bias (%) 95% Condence Interval [-128.04, 5.28] [-94.49, -49.38] [49.95, 124.07] [42.05, 67.63] [165.82, 189.68] [289.75, 386.26]

9.15 (6.08) 2.30 (0.82) 0.24 0.99

-109.54% 8.12% 2.69% -1.57% 0.14% 0.29%

Panel G: Regression Adjusted Local Linear Matching on both Controls and Treated Credit Rating of Bank Loan and Bond AA A BBB BB B CCC Bond Bank Spread Basis Points (8.77) (77.98) 74.88 60.60 181.96 309.90 Standard Error Basis Points 14.77 16.54 14.97 10.87 6.08 16.04 Bias Bias (%) 95% Condence Interval [-40.76, 6.02] [-106.37, -50.54] [39.49, 95.45] [43.14, 84.65] [169.40, 191.65] [282.97, 347.42]

8.60 (6.53) (1.41) (1.20) (0.15) (2.68)

-98.15% 8.37% -1.88% -1.97% -0.08% -0.87%

Agency Costs, Bank Specialness and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

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