Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests

54 Pages Posted: 26 Nov 2011 Last revised: 25 Sep 2022

See all articles by B. Espen Eckbo

B. Espen Eckbo

Tuck School of Business at Dartmouth; European Corporate Governance Institute (ECGI)

Xunhua Su

Norwegian School of Economics (NHH)

Karin S. Thorburn

Norwegian School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

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

Eckbo, B. Espen and Su, Xunhua and Thorburn, Karin S., Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests (September 20, 2022). Tuck School of Business Working Paper No. 1964843, European Corporate Governance Institute – Finance Working Paper No. 770/2021, Available at SSRN: https://ssrn.com/abstract=1964843 or http://dx.doi.org/10.2139/ssrn.1964843

B. Espen Eckbo (Contact Author)

Tuck School of Business at Dartmouth ( email )

Hanover, NH 03755
United States
603-646-3953 (Phone)
603-646-3805 (Fax)

HOME PAGE: http://tuck.dartmouth.edu/faculty/faculty-directory/b-espen-eckbo

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Xunhua Su

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

HOME PAGE: http://sites.google.com/site/xunhuasu/

Karin S. Thorburn

Norwegian School of Economics ( email )

Helleveien 30
N-5045 Bergen
Norway
+4755959283 (Phone)

HOME PAGE: http://www.nhh.no/cv/thorburn

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
540
Abstract Views
5,340
Rank
94,653
PlumX Metrics