Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests
Tuck School of Business Working Paper No. 1964843
European Corporate Governance Institute – Finance Working Paper No. 770/2021
54 Pages Posted: 26 Nov 2011 Last revised: 25 Sep 2022
There are 2 versions of this paper
Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests
Bank Compensation for Penalty-Free Loan Prepayment: Theory and Tests
Date Written: September 20, 2022
Abstract
Commercial and industrial bank loans typically include an option to prepay the loan without penalty (zero cancellation fee). We present a first analysis of how banks must be compensated for this option. Borrowers use the loan to fund investment projects and subsequently receive non-contractible information about project payoff. As high-quality borrowers self-select to prepay, the credit-quality of the bank's borrower pool deteriorates. Hence, to avoid credit rationing, the bank must be compensated upfront with a minimum upfront fee combined with a lower loan spread. The upfront fee dominates the alternative of a cancellation fee as the latter gives rise to opportunistic ex post bargaining with the bank's preferred clients. Large-sample tests, which include exogenous industry-level variation in loan prepayment risk, confirm that upfront fees increase with prepayment risk and are lower in credit lines and loans with performance-sensitive pricing, as predicted.
Keywords: bank loans, prepayment, credit rationing, upfront fee, performance-pricing
JEL Classification: D82, D86, G21, G32
Suggested Citation: Suggested Citation