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

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

B. Espen Eckbo, Xunhua Su, Karin Thorburn

Series number :

Serial Number: 
770/2021

Date posted :

July 01 2021

Last revised :

January 10 2022
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Keywords

  • bank loans • 
  • prepayment • 
  • credit rationing • 
  • upfront fee • 
  • performance-pricing

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.

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.

Authors

Real name:
Xunhua Su