November 16, 2007

Whats Different about Banks? Depositor Discipline and Active Monitoring

by Michael F. Ferguson* and Bradley A. Stevenson**

JEL Codes: G20, G21, G30, G32 *Department of Finance, College of Business, University of Cincinnati, P.O. Box 210195, Cincinnati, Ohio 45221-0195; (513) 556-7080; e-mail: michael.ferguson@uc.edu. **Department of Finance, The College of Business, University of Akron, 302 Buchtel Mall, Akron, Ohio 44325; (330) 972-6332; e-mail: stevenb@uakron.edu. This paper is based in part on Chapters 1 and 2 of Stevensons dissertation at the University of Cincinnati. We thank Rosalind Bennett, Bob Hunt, Shane Johnson, Jack Reidhill, Steve Slezak, Todd Vermilyea, Steve Wyatt, Yan Yu and seminar participants at the 2007 FMA Conference, the Federal Reserve Bank of Philadelphia, the University of Akron, and the University of Cincinnati for helpful comments on earlier versions of this paper.

Whats Different about Banks? Depositor Discipline and Active Monitoring

In this paper we provide an empirical link from Fama (1985) and James (1987) observation that banks are special to Diamond and Rajans (2001) model of the banking firm as an active monitor financed with demandable debt. Drawing on a sample of 423 bank loan announcements made during 1988-1996, we document that borrower abnormal announcement returns are positively related to proxies for the banks ability (or incentives) to monitor. Using a sample of 4,534 bank loans originated during 1987-2003, we find that an index of superior monitoring ability based on these factors is positively related to the loan yield spreads paid by bank borrowers. These two findings are evidence that 1) bank borrowers pay a premium for bank monitoring services; and 2) the excess returns associated with bank loan announcements are in fact a reflection of the monitoring benefits generated by the bank. The proxies that are related to both abnormal announcement returns and borrower spreads are 1) the ratio of the banks uninsured deposits to total loans, 2) a risk-adjusted measure of recovered charge offs , and 3) the banks relative capital ratio. Thus, our results reveal a heretofore empirically undocumented benefit of uninsured demand deposits: they appear to improve the banks incentives to monitor borrowers. The first two proxies are strikingly consistent with the theory of banking laid out in Diamond and Rajan (2001). As predicted by Diamond and Rajan (2001), our empirical results indicate that, for the best bank monitors, monitoring skill and fragile (uninsured) demand deposits co-exist.

1.

Introduction What is different about banks? Fama (1985) and James (1987) document that CD

rates are equivalent to, but not lower than, the rates paid on other comparable securities. From this they conclude that the reserve requirement for CDs must be borne by the banks borrowers. Fama conjectures that borrowers choose to bear this implicit tax burden because of the special monitoring services that the bank provides. James (1987) further documents that bank loans are special in the sense that, unlike other security offerings, bank loan announcements are associated with positive abnormal returns1. Diamond and Rajan (2001) have developed an explanation for the existence of specialized lenders that emphasizes two aspects of the bank. First, consistent with

Famas conjecture, banks are active monitors of their borrowers; they are engaged in ongoing relationships that generate private, specialized knowledge about their borrowers assets. This specialized knowledge gives them an advantage relative to other lenders. Intuitively, the borrowers collateral is worth more to the specialized lender than to any other lender. Thus, the lender fares better (recovers more) than another lender would if the borrower becomes distressed. Second, the capital structure of banks is inherently fragile due to their heavy reliance on demand deposits. They argue that the fragile nature of the demand deposit contract is a desirable feature that is critical to the provision of monitoring services. In their model, the uninsured depositors will run the bank if the lender does not in fact develop and employ their specialized knowledge. Thus, the

Lummer and McConnell (1989), Slovin, Johnson, and Glasscock (1992), Best and Zhang (1993), Billet, Flannery, and Garfinkel (1995), Johnson (1997a), and Hadlock and James (2002) also document positive abnormal returns for bank loan announcements. These studies are evidence that the bank-borrower relationship benefits the borrower. This implies that ending it would be bad for the borrower. To this end, Dahiya, Puri, and Saunders (2003) document that loan sales result in negative abnormal returns and Guner (2006) finds that borrows pay lower rates on loans from banks that regularly sell their loans.

presence of the uninsured depositors provides the proper incentives to the bank to monitor the borrower. The key point: it is the combination of these two elements active monitoring and a fragile capital structure that is essential to the nature of banks. In this paper we establish an empirical link from Fama and James observation that banks are special to Diamond and Rajans model of the banking firm as an active monitor. We identify a small set of proxies for the banks ability and incentives to monitor borrowers that are associated with higher excess returns surrounding bank loan announcements. The specific proxies that are related to abnormal announcement returns are 1) the ratio of the banks uninsured deposits to total loans, 2) a risk-adjusted measure of recovered charge offs, and 3) the ratio of the banks relative capital ratio. The concurrent importance of uninsured demand deposits and the banks ability to recover charged off loans is strong evidence in support of the Diamond and Rajan model of banking. We construct an index of superior monitoring ability (or incentives) based on these characteristics. For a different, and much larger, sample of bank loans this index of superior monitoring ability is positively related to the interest rate spreads paid by bank borrowers. These findings are evidence that 1) bank borrowers pay a premium for bank monitoring services; and 2) the excess returns associated with bank loan announcements are in fact a reflection of the monitoring benefits generated by the bank. This linkage of lender characteristics to both loan announcements returns and the rates charged by banks is the primary contribution of our paper. Our study is the first to link the same bank characteristics to both the costs and the benefits associated with bank lending. This is the most comprehensive evidence to date in support of Famas hypothesis that banks are

special because they are active monitors. Moreover, our evidence is consistent with the key points of the Diamond and Rajan (2001) model. The evidence in support of the active monitoring hypothesis is significant because it is not the only possible explanation for the positive abnormal returns first documented by James (1987). An alternative explanation for the specialness of banks originates in Campbell (1979) and is developed by Bhattacharya and Chiesa (1995) and Yosha (1995). They argue that firms approach banks for strategic reasons. In particular, the firm values the confidentiality that a bank lending arrangement affords relative to a public security offering (debt or equity). The bank does not necessarily play any screening or

monitoring role, its primary purpose is to provide capital without requiring public disclosure of firm secrets. Thus, the bank loan signals to the market that the borrower has a valuable investment idea, business plan, strategy etc. that they are concealing from their competitors. Obviously, this explanation is also consistent with positive abnormal Although the active monitoring and

returns following bank loan announcements.

confidentiality hypotheses are not mutually exclusive, there is a strong argument that our results favor the active monitoring hypothesis. If the service the bank provides is merely confidentiality, then any bank can provide it. Therefore, we should not observe a strong relationship between the cross-sectional variation in the rates that borrowers are willing to pay and any bank characteristics. Similarly, the markets reaction to bank loan

announcements should not vary with the identity of the lender. Below we will link lender characteristics to both the magnitude of the loan announcement abnormal returns and to the size of the interest rate spreads charged by borrowers. Therefore, we conclude that the data is more consistent with the active monitoring hypothesis.

The plan of the rest of the paper is as follows. Section 2 relates our findings to several branches of the extant literature. In Section 3 we describe our sample of bank loan announcements. Section 4 details our empirical proxies for monitoring ability and examines the relationship between those proxies and bank loan announcement abnormal returns. Section 5 develops our superior monitoring proxy and documents that borrowers pay higher interest rate spreads to the lenders our methodology identifies as superior monitors. Section 6 concludes.

2. Related Literature The evidence in this paper contributes to several strands of the banking literature. The beneficial role of uninsured demand depositors in monitoring the bank was first emphasized by Calomiris and Kahn (1991). Since then there have been several empirical studies of the degree to which demand depositors monitor the bank.2 These generally take the form of determining whether uninsured depositors demand greater risk premiums as a banks financial situation weakens (e.g.,Park and Peristiani (1998)) or whether demand depositors in fact leave the bank (run, perhaps) as its condition deteriorates (e.g., Billet, Garfinkel, and ONeal (1998), Goldberg and Hudgins (1996, 2002), and Park and Peristiani (1998)). Our evidence is of an altogether different sort. Earlier studies document the costs (runs; greater risk premiums) associated with monitoring of the bank by demand depositors. We are the first to provide evidence of the benefits (improved monitoring of borrowers) that arise because they facilitate monitoring by the bank.

Flannery (1998) surveys the literature on market discipline of banks. The role of uninsured demand depositors is prominently featured.

Billet, Flannery, and Garfinkel (1995) represents the first attempt to associate lender characteristics with bank loan announcement returns. Their intuition is simple. Entering into a borrowing relationship with a lender with a better reputation should lead to better announcement day returns. They find that their proxy for lender reputation, the lenders credit rating, is positively associated with the abnormal returns surrounding bank loan announcements. Johnson (1997a) notes that the greatest excess returns reported by Billet, Flannery, and Garfinkel (1995) are for the loans by unrated banks. This is odd if the credit rating is really a proxy for the lenders monitoring reputation. Johnson (1997a) reports that, in fact, bank credit ratings are unrelated to the abnormal returns associated with bank loan announcements after controlling for reputation proxies drawn from the auditing literature: bank size, bank capital, and the banks loan loss provision.3 Even if we accept that Johnson (1997a) has identified the characteristics that make banks special, there is still an empirical link missing in Famas (1985) logical chain that ends with the conclusion that borrowers are paying for the monitoring ability of the bank. Namely, while we now have ample evidence that borrowers benefit from bank loans, we have yet to document that borrowers pay banks a premium for any particular service. Guner (2006) has recently provided some suggestive evidence on this score. He reports that loans originated by banks that are active sellers of loans and, hence, not likely to be providing any ongoing specialized monitoring services to the borrower command lower spreads. This clearly indicates that borrowers place value on
3

Lee and Sharpe (2004) relate monitoring quality, or ability, to the labor inputs in the monitoring process. Therefore, they create the following proxies for monitoring ability: the ratio of employee salaries to noninterest expense and average salary per employee. Their conjecture is that monitoring is a labor intensive process and the amount spent in total and per employee should indicate the amount and quality of monitoring respectively. Indeed, they find that both of these proxies help explain the significant positive returns of loan announcements. As in Johnson (1997a), bank ratings are no longer significant when both salary and ratings proxies are used together.

the long-term lending relationship. Our paper completes the task of connecting whats different about banks (i.e., the incentives and ability to monitor) with the borrowers costs. Finally, we extend the recent literature that examines the relationship between lender characteristics and the interest rates paid by borrowers. As noted, Guner (2006) hypothesizes that borrowers receive price concessions when the lender is able to sell the loan. Consistent with this he finds that the yield spread over LIBOR on loans originated by active sellers is significantly lower than the spreads on loans made by other lenders. Hubbard, Kuttner, and Palia (2002) argue that if borrowers face high switching costs (perhaps because of the importance of the long-term lending relationship) weak banks may be able to pass along higher capital costs. They regress the spread over LIBOR on bank capital while controlling for numerous bank, borrower, and contract characteristics. They find that weaker banks are able to charge higher spreads. Cook, Schellhorn, and Spellman (2003) posit that borrowers pay for certification services. Following Billet, Flannery, and Garfinkel (1995) they employ the lenders credit rating as proxy for its reputation. As in Johnson (1997a) they use also utilize size as a reputation proxy. They find that lenders with better reputations as measured by greater total assets (size) and higher bond ratings are able to charge higher spreads over LIBOR. Kim, Kristiansen, and Vale (2005) employ a similar experimental design to Cook, Schellhorn, and Spellman (2003) using Norwegian bank data. They use three proxies for bank quality: total assets, capital ratio, and loan loss provisions. Contrary to their expectations (but consistent with Hubbard, Kuttner, and Palia) they find that the capital ratio is significantly negatively related to the rate spreads charged by banks. In contrast to Cook, Schellhorn, and

Spellman (2003) they find no relationship between firm size and interest rate spreads. The only quality variable that they identify as affecting spreads significantly in the expected direction is loan loss provision. Banks with lower expected losses are able to charge higher rates. Our contribution to the determinants-of-borrowing-costs literature is to relate loan yield spreads to a specific bank service monitoring via our index of bank monitoring ability. The significance of this particular index is that it is based on bank characteristics that we have previously shown to be related to bank loan announcement effects.

3. 3.1.

Commercial Bank Loan Announcements Data We searched Factiva for announcements of loans by commercial banks to non-

financial firms that appeared on the Reuters wire, Dow Jones Newswires, or in The Wall Street Journal from 1988 to 1996.4 One thousand and sixty-five bank loan Articles were

announcements, either wire stories or print articles, were identified.

selected for the initial sample if any of the following terms were contained within the body or title of the article: line of credit, credit line, credit facility, credit agreement, credit extension, new loan, loan agreement, loan renewal, loan revision, loan extension, finance company loan, term loan, commercial loan, bank loan, loan facility, or working capital facility. For each announcement we collected the borrowing firms name, date of the announcement, the identity of the lead lender or lenders, other lenders in the syndicate,

Loans, as used in this paper, are often unfunded agreements. The loans collected here include agreements such as revolvers, term loans, working capital agreements, etc.

whether the loan was an initiation or renewal, the amount of the facility, the amount of any previous agreement, loan maturity, purpose of the loan, any changes to interest rates and covenants, and the type of loan. If the lender was not identified in the announcement it was dropped from the sample. From the initial set of announcements a clean sample, free of confounding news releases, was created. Loan announcements are considered contaminated if a story appeared within one day on either side of the loan announcement date that included information about items such as dividends, earnings announcements, managerial changes, joint ventures, assets sales/purchases, or new product announcements. Removing these observations from the initial sample leaves a clean sample of 692 loan announcements. In addition to loan announcements, we need stock returns from CRSP to compute borrower abnormal returns as well as various COMPUSTAT data for each lender and borrower. Lack of COMPUSTAT data eliminated 108 announcements and lack of CRSP data eliminated another 66. After dropping 35 REIT borrowers and four financial firms, the final sample consists of 478 loan announcements. Descriptive statistics for this final sample are provided in Panel A of Table 1. We were unable to collect lender data in 55 cases. The descriptive statistics for this reduced sample appear in Panel B. [Table 1: Characteristics of Bank Loan Announcements] The mean borrower size for the full sample is around 16% larger at $533.9 million than the FDIC sample mean firm size at $460.9 million. The median borrower size for the two samples is nearly identical with the median size of a full sample firm being $130.4 million compared to $131.2 million for a borrower in the FDIC sample. The mean and median loan sizes and loan maturities are also very similar across the two

samples. One significant difference is the size of the loan divided by the market value of the borrowers equity for the full sample is twice that of the FDIC sample; however, the medians for the two samples are very close. Thus, there is very little difference in the full sample of loan announcements and the subsample for which we are able to gather lender data. 3.2. Univariate Analysis [Table 2: Two-day Standardized Prediction Errors] Table 2 reports average two-day standardized prediction errors for the full sample and for various subsamples based on lender characteristics. The standardized prediction errors are computed using the standard event study methodology employed by James (1987), Lummer and McConnell (1989) (LM), Slovin, Johnson, and Glascock (1992) (SJG), Billett, Flannery, and Garfinkel (1995) (BFG), and Johnson (1997a).5 Table 2 illustrates that commercial bank loan announcements are associated with positive excess returns. The average abnormal return (PE = .91%) is larger than that reported in most previous studies6 and it is significantly different from zero (z = 3.11). Note that 54.60% of the sample has a positive announcement effect. This is nearly identical to the

proportions reported in BFG (54.1%) and Johnson (54.5%). Additionally, this is greater than the proportion found by LM (48.5%) and SJG (50.7%), but is smaller than the proportion of positive announcement effects in James (66%).

A two day announcement window is used because wire service announcements may arrive after the close of trading on day zero. This late arrival would cause the information not to impact the market until the day after the announcement day. The market model used to create the prediction errors is estimated using 100 trading days before, t = -120 to -21, and 100 days after, t = 21 to 120, the announcement date. 6 The two-day abnormal return is 1.93% in James (1987), but only .61%, .32%, and .68% in Lummer and McConnell (1989), Best and Zhang (1993), and Billett, Flannery, and Garfinkel (1995), respectively.

The univariate analysis reveals that for all but two (loan yield and capital ratio) the abnormal returns associated with a bank loan announcement are greater when the lender characteristic is above the median value. However, the only statistically

significant difference is for uninsured deposits. The mean prediction error is more than 4 times greater (1.45% vs. .33%) for loans made by lenders in the top half of uninsured deposits. 3.3. Cross-sectional Variation in Abnormal Returns The sample exhibits rich cross-sectional variation. The maximum and minimum excess returns are 47.63% and -15.44%, respectively, for a range of 63.07%. The interquartile range is a more representative measure of spread than the range. In our sample it is 4.46% (high quartile = 2.93%; low quartile = -1.53%). The only previously reported inter-quartile range that we are aware of is in Johnson (1997a). His sample has an interquartile range of .88% (high quartile = 1.78%; low quartile = .90%). Figure 1 is a plot of the standardized excess returns for our sample. [Figure 1: Distribution of Two-Day Standardized Prediction Errors] Our ultimate goal is to relate variation in bank loan announcement returns to lender characteristics. For this purpose, the cross-sectional variation is a more important distributional characteristic than the mean. It is clear from Figure 1 and the range statistics that there is substantial cross-sectional variation in our sample. Therefore, the analysis of the relationship between the prediction errors and the proxies for active bank monitoring can proceed.

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4.

What are the Characteristics of a Good Monitor? Whats different about banks? In the years since Fama (1985) asked this famous

question, there have been a number of studies that have revisited James (1987) evidence for the specialness of bank loans.7 James and Smith (2000) fairly summarize what weve learned: In general, these studies suggest that private lenders add the greatest value for so-called informationally-intensive borrowersborrowers who face the greatest potential information problems when issuing public securitiesThe fact that bank loans are collateralized, contain strict covenants, and are typically short term improves a banks ability to monitor informationally-intensive loans. That is, we know something about whats different about the borrowers who benefit from bank lending8 and we know something about whats different about their loan contracts. Significantly, we have not made much progress identifying the distinguishing characteristics of the banks that make the most beneficial loans. As a first step towards this objective we note that banks invest in monitoring technologies, hire skilled employees, gain experience through time, etc. As a result, they are able to specialize in offering monitoring services to borrowers. Furthermore, they may use incentive

contracts, capital structure, etc. to ensure that the specialized monitoring ability that has been developed is efficiently put to use. Thus, the most specialized banks are able to create credible, attractive niches for themselves as superior monitors. We propose to explain the variation in prediction errors surrounding loan announcements using proxies for the degree of monitoring incentives and ability developed by each bank.
See footnote 1. A closely related literature focuses on the choice between public debt and private debt (primarily bank loans). Recent examples include Denis and Mihov (2003) or Hadlock and James (2002). This literature also focuses on the characteristics of the borrower and reaches broadly similar conclusions to the studies that focus solely on bank loans. Issuers that face greater adverse selection problems prefer private lenders (particularly banks).
8 7

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4.1

What is Monitoring? The theoretical literature draws a vivid picture of bank monitoring. A common

theme dating back at least to Kane and Malkiel (1965) and Black (1975) is that banks monitor some aspects of their borrowers activities. More recent research builds on the idea that relative to other lenders banks have superior monitoring technologies.9 More precisely, banks develop detailed knowledge of a borrowers investment opportunities, influence project choice and, importantly, influence effort choice. In this sense, bank debt truly is inside debt. Besanko and Kanatas (1993) describe bank monitoring as an active process of tracking effort exerted by the entrepreneur. In their model the bankfirm relationship is a long-term relationship in which the bank can monitor items such as the firms collateral balances, financial transactions, and agent effort. In this type of environment, banks have a direct influence on borrower decisions. This view of

monitoring is consistent with the view of banks as relationship lenders. Boot (2000) defines relationship lending as repeated interactions over time with the same borrower that allows the bank to develop firm-specific, private information. As Rajan (1992) observes, this intimate knowledge of a borrowers projects can be so extensive as to give the lender a decided bargaining advantage over the borrower. So, in short, monitoring is an active, on-going, intrusive, and ultimately expensive process that requires skill and proper incentives.

See for example Chan (1983), Diamond (1984, 1991), Ramakrishnan and Thakor (1984), Berlin and Loeys (1988), Rajan (1992, 1998), Besanko and Kanatas (1993), Rajan and Winton (1995), Holmstrom and Tirole (1997), and Diamond and Rajan (2001).

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4.1.1. Uninsured Deposits Diamond and Rajan (2001) and Calomiris and Kahn (1991) have emphasized the monitoring role that uninsured depositors play in disciplining bank management. Following this intuition, we propose that banks with more uninsured deposits will be better monitors because, in turn, they are being monitored by their depositors. Johnson (1997a) used total deposits, insured and uninsured, because he was using size as a proxy for the banks reputation. To avoid conflating our proxy with bank size and to enable us to focus on the disciplining effect of deposits, we create our proxy by dividing total uninsured deposits by total loans.10 Banks with a low ratio will not face much discipline from depositors, while those with high ratios will face greater discipline and monitor more intensely. Therefore, for greater ratios of deposits (over $100K) to loans, we expect to see a greater (more positive) announcement effect. 4.1.2. Capital Ratio The second proxy is derived from Besanko and Kanatas (1993) and Holmstrom and Tirole (1997). In Besanko and Kanatas (1993), entrepreneurs exert effort in relation to their stake in the firm. Outside funding decreases the entrepreneurs incentive to exert effort and consequently decreases the probability of project success. The bank varies its level of monitoring intensity in order to induce the borrower to make a better (for the lender) effort choice. In effect, bank monitoring substitutes for the incentive provided by equity capital. An issue in their model is the moral hazard problem that arises because the bank cannot commit to a level of monitoring. Holmstrom and Tirole (1997) develop a related model. The key insight for our purposes is that a banks commitment to monitoring varies with the level of its own
10

Deposit accounts up to $100,000 are insured. Amounts in excess of this level are reported as uninsured.

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capital. As in Besanko and Kanatas (1993), the entrepreneurs effort is a function of its equity position. So, in Holmstrom and Tirole (1997) the bank effectively substitutes its own capital (through the incentive to monitor) for the borrowers capital.11 In order to exploit their insight, our proxy is the ratio of two capital ratios: total bank equity to total bank assets divided by total firm equity to total firm assets. An increase in the proxy ratio indicates the bank has greater incentive to monitor. Therefore, we expect that larger values of this variable should be associated with greater excess returns. 4.1.3. Recovered Charge-Off % Diamond and Rajan (2001) argue that the banks comparative advantage in relationship lending is that, via monitoring, it acquires specialized knowledge of the borrowers assets. This gives the lender an advantage in liquidating those assets. This suggests that the best monitoring lenders should be able to recover the greatest proportion of previously charged off loans. To proxy for this we look at the ratio of recovered charge-offs to total charge-offs. Better monitors may attract riskier loans. Therefore, a bank that is better in an absolute sense at liquidating assets may have a lower Recovered Charge-Off %. To account for this we must control for the risk of the banks loan portfolio. We will discuss our bank risk proxy in detail below. Our hypothesis is that after controlling for bank risk (through an interaction term), Recovered Charge-Offs will be positively related to abnormal returns.

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As they note, the banks managers are not likely to be the banks owners. They argue that the managers of such intermediaries have access to a stream of private benefits that is related to the amount of assets under management. In this setting, the mangers incentive to monitor is the same as if they owned the bank.

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4.1.4

Loan Yield Bernanke and Gertler (1989) develop an optimal auditing model of bank

monitoring.

The intuition in Bernanke and Gertler (1989) is as follows. The higher

repayment (i.e., loan yield) demanded by the lender for a riskier investment lowers the consumption of the borrower in the good state (which is when repayment occurs). The lower consumption in the good state reduces the potential opportunity cost of falsely claiming that the bad state has occurred. This increases the moral hazard of the borrower and the need for costly monitoring by the bank. Thus, the Bernanke and Gertler (1989) model suggests that lenders charge riskier borrowers higher rates to compensate for risk and the cost of monitoring the borrower. After controlling for the risk of the banks loans, the average yield earned by the lender should proxy for the amount of monitoring the bank is performing in its lending relationships. As with the Recovered Charge-Off %, we must control for bank risk. Therefore, the hypothesis for the interaction variable is that the coefficient should be positive since for a given level of risk higher yields equate to more monitoring. From the FDIC database, this proxy is formed by taking the ratio of fees and interest on commercial and industrial loans to the total dollar amount of commercial and industrial loans. The notion of the bank as a relationship lender raises an interesting point first noted by Sharpe (1990) and expounded upon in Rajan (1992). They have argued that relationship lending can lead to the capture of the borrower. In Rajans (1992) model the bank gains specific knowledge about the firms projects (e.g., NPVs; and, hence, borrowers reservation prices) that give it bargaining power over the lender. This

argument implies that high loan rates are not a signal of a strong incentive to monitor.

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Instead, high loan rates may be a signal of hold-up problems and greater bank bargaining power allowing it to capture more of the surplus partially created by its monitoring. In this case, we would expect to see a negative coefficient on our proxy. After controlling for risk, higher yields would indicate that the bank is capturing a larger share of the gains from trade. 4.1.5. Loan Commitments / Total Bank Assets The last monitoring proxy that we will introduce is implied by many of the theoretical papers mentioned above, but it is most explicitly modeled in Rajan (1998). In his model banks lend to clients in order to maintain their reputation as providers of liquidity. But, through their monitoring activities they know when not to lend to the firm; i.e., banks know when the loss of reputation from not lending will be less than the direct loss they expect to incur from a bad loan. Thus, banks that provide liquidity through standby letters of credit and loan commitments need to be superior monitors in order to provide liquidity while maintaining their reputations. The proxy proposed for this is the ratio of standby letters and loan commitments to total bank assets. The higher the ratio, the greater the banks incentive to monitor, and, therefore, we anticipate that the excess returns on loan announcements will be positively associated with this proxy. 4.2. Control Variables

4.2.1. Past Due Loans As noted above, it is necessary to control for the risk of the banks loan portfolio when interpreting Recovered Charge-Off % and Loan Yield. Financial regulators look to past due loans as an indicator of the quality of a banks loan portfolio. Additionally, Berger, King, and OBrien (1991) document that the ratio of past due loans to total assets

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predicts future bank problems. Therefore, we use this as our measure of bank portfolio risk. Specifically, we employ a three year average of this ratio. Borrowing from a bank that exhibits a risky loan portfolio may be taken as a signal by the market that the new borrower is just like the rest of them. This suggests that, by itself, Past Due Loans might be a bad news variable and be negatively associated with excess returns. However, as noted above, as a control variable interacted with Loan Yield or Recovered Charge-Off % we anticipate a positive relationship with announcement returns. 4.2.2. Borrower Characteristics: Public Debt Firm Size, Equity Volatility, Price Run-Up, and

We control for several borrower characteristics that have been previously shown to be associated with abnormal loan announcement returns. Slovin, Johnson, and Glasscock (1992) reports that smaller borrowers have greater abnormal returns than larger borrowers. Billet, Flannery, and Garfinkel (1995) and Johnson (1997a) find that RunUps are negatively associated with abnormal returns. We compute Run-Ups using the cumulative return over the previous ten days prior to the loan announcement. BFG

(1995) and Hadlock and James (2002) find that the volatility of the borrowers equity returns (Stock Volatility) is positively associated with excess returns. Finally, HJ (2002) use a public debt dummy as a proxy for the relative contracting costs of bank debt. They hypothesize that borrowers with outstanding public debt have relatively higher costs of using bank debt and that, therefore, if they use bank debt it is only when the benefit to doing so will be great (i.e., higher abnormal returns). Their findings are consistent with their hypothesis.

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4.2.3. Contract Term: Maturity and Relative Loan Size We control for the maturity of the loan. We also control for the size of the loan relative to the borrowers equity in order to capture any effects due to material changes in the borrowers leverage. 4.3. Data To construct the bank monitoring proxies, lender bank data for the 478 loan announcements described above was collected from the call report data at the Federal Reserve Bank of Chicago.12 For each lead lender we recorded total loans, total assets, total C&I loans, fees and interest on C&I loans, owners equity, total deposits, deposits over $100,000, deposits under $100,000, the amount of loan commitments, the amount of non-accrual and past due loans, and the amount of predicted loan losses. FDIC data was missing for 55 lenders. This reduces the number of bank loan announcements to 423. The characteristics of these loans are reported in Panel B of Table 1. The characteristics of the proxies formed from the call report data are given in Table 3. [Table 3: Characteristics of Proxies for Bank Monitoring] If both a commercial bank and either a foreign bank or investment bank are mentioned as the lead lender or arranger then the domestic commercial bank is treated as the lead lender.13 If an announcement identifies one bank (of possibly many) as the lead lender, data is collected for that lender only. If multiple banks are mentioned but there is no indication of rank, data is collected for all lenders.14
12

Call report data is collected by the FDIC on a quarterly basis and include data on each individual banks condition including income, assets, and liabilities. 13 Extant theory and empirical evidence indicates that that there is something special about commercial banks relative to other lenders. Therefore, we take as given that the commercial bank is selected to be a colead for its monitoring ability and thus we treat that firm as the lead lender. 14 In the analysis to follow, we form a composite bank by selecting the best statistics among all the co-leads given the hypotheses described above. The intuition for this approach is that the firm selected these banks

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4.4.

Multivariate Analysis of Excess Returns [Table 4: The Effect of Lender Monitoring Incentives on Borrower Returns] Table 4 reports the results of regressing the two-day prediction errors on various

subsets of the monitoring proxies and control variables described in 4.1 and 4.2. Three strong proxies for bank monitoring emerge from the empirical analysis; Uninsured (the disciplining effect of deposits, motivated by Calomiris and Kahn (1991) and Diamond and Rajan (2001)); Capital Ratio (a measure of the incentive to substitute bank capital for firm capital, motivated by Besanko and Kanatas (1993) and Holmstrom and Tirole (1997)); and, Recovered Charge-Off %*Past Due Loans (a measure of the risk adjusted ability of the lender to make better use of the borrowers assets, motivated by Diamond and Rajan (2001). Model (1) in Table 4 is the regression of the standardized two-day prediction errors on lender characteristics without any of the control variables. Uninsured Deposits, Capital Ratio, Recovered Charge Off%, and Recovered*Past Due are all significant. The negative coefficient on Recovered Charge Off% is consistent with the intuition in Section 4.1.3 that better monitors attract riskier loans. This effect is great enough to create a significant difference between the recovery rates of superior monitors and other banks. Thus greater unadjusted recovery rates indicate inferior monitoring ability. This

interpretation is further supported by the results for the interaction term, Recovered*Past Due. This term has a positive coefficient indicating that, for given a level of portfolio risk, higher recovery rates are an indication of superior active monitoring ability. This is what we expected. The positive coefficient for Uninsured Deposits is as expected and it

together instead of a single bank because of the different monitoring qualities they possessed. In other words, the firm designed its own bank in selecting the co-leads.

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is significant. This supports the hypothesis that uninsured demand depositors improve the banks incentive to monitor its borrowers. Note that this is a positive attribute of having uninsured deposits. The positive sign on Capital Ratio, as well as its significance, indicate that the ability of a bank to effectively substitute its own capital for the capital of the borrower is valuable. Loan Yield*Past Due is insignificant and the sign is the opposite of our expectation while LC/Bank Assets is also insignificant, but its sign is in the expected direction. Control variables are added to generate model (2), reported in Table 4. The control variables have very little effect on the borrower characteristics. The regression coefficients for our new proxies are virtually unchanged from their values in model (1). In addition, the significance level for all four variables is equivalent to the results from the first column. Among the controls, Log (MV of Equity), Stock Return Variability, Public Debt Dummy, Loan Size/MV Equity, and Maturity are all insignificant. Run Up is significant (z = of 2.67). Consistent with Billet, Flannery, and Garfinkel (1995) and Johnson (1997a), Run Up is negatively related to excess returns on loan announcements. Models (4) and (5) estimate model (2) separately for large and small firms, respectively. The model does not fit the smaller data sets as well. For large firms, the existence of public debt emerges as a significant variable. A firm that has public debt outstanding that announces a bank loan earns significantly higher abnormal returns. This is consistent with Hadlock and James (2002). For small firms, Uninsured is the most significant variable. This is consistent with Slovin, Johnson, and Glascocks (1992) notion that smaller firms are the primary beneficiaries of bank monitoring.

20

Model (3) in Table 4 reports the results of the regression equation arising from backward reduction. Backward reduction removes variables one at a time until only those with significant explanatory power are left. After performing this procedure,

Recovered Charge Off%, Recovered*Past Due, Recovered Charge Off%, Uninsured Deposits, Loan Yield*Past Due, and Run Up are all shown to be significant explanatory variables of the excess loan announcement returns. Unlike models (1) and (2), Loan Yield*Past Due is now significant. The negative coefficient indicates that, for a given level of portfolio risk, banks with lower yields are associated with higher excess returns. This is counter to our expectation if higher rates proxy for the banks incentive to monitor. However, as noted above, it is consistent with the hypothesis that a relationship lender may capture its borrower and capture a greater share of the surplus created by its monitoring ability. Although this variable is significant, its sign suggests that it is not a

proxy for monitoring. Therefore, we will not use it in Section 5 when we create the index of monitoring ability. 4.5. Summary In this section we identified three bank characteristics that are associated with greater bank loan announcement excess returns. The proxies were derived from

theoretical models of banking that emphasize the monitoring role of the bank. Thus, we interpret the results as indicating that the specialness of bank loans identified by James (1987) and others is due to banks having superior monitoring skills and incentives relative to other lenders. The results indicate that both uninsured depositors and bank capital play a role in disciplining banks by giving them greater incentives to monitor. In addition, the evidence for recovery rates indicates that through their ongoing relationships

21

with borrowers, banks are able to closely monitor them and learn valuable private information about a borrowers business and alternative uses for its assets. Finally, the negative relationship between the yield on a banks loans and the abnormal returns from bank loan announcements is consistent with the banks relationship giving it some ability to extract greater surplus from borrowers.

5.

Are Superior Monitors Able to Earn a Premium? The regressions in Section 4 identified several lender characteristics that appear

to proxy for monitoring ability. In this section we conduct an out-of-sample test of the relationship between these characteristics and the rates paid by borrowers. We want to examine Famas (1985) hypothesis that borrowers are willing to pay a premium for the special monitoring services provided by banks. If superior monitors are compensated for their ability, this would also explain why all firms do not contract with superior monitors. 5.1 Classifying Superior Bank Monitors The key to the analysis of interest rate premiums is the identification of bank monitoring ability. The following lender characteristics were shown to be associated with positive bank loan announcement effects: %*Past Due Loans, and Capital Ratio. Uninsured, Recovered Charge-Offs

We develop a classification scheme based on

these characteristics to identify superior bank monitors. For each lender characteristic, we compare each lender to the median value of that characteristic in the sample. We consider any lender above the median value to be a

superior monitor along that dimension. Lenders with superior rankings in at least 2 of the

22

3 categories form our superior monitoring group. This metric classifies 3,635 banks (out of 6,709 in our sample) as superior monitors. 5.2 Data In order to examine individual loans between firms and commercial banks, we gathered data from the DealScan database which is a product of the Loan Pricing Corporation (LPC). The database contains loans for both public and private firms. While there are a few loans in the database before 1987, broad coverage begins in 1987. We collected all loans to U.S. and Canadian firm in the database from 1987 to 2003. Some of the loans consist of multiple tranches. In the sample, there are 55,595 Although we collected information on each tranche,

loans representing 78,444 tranches.

in the empirical tests we will examine each transaction at the deal level, not at the tranche level. The following items were collected for each loan: borrower name and country, deal status, deal amount, tranche amount, tranche type, loan purpose, tranche maturity in months, tranche expiration date, base rate, margin, upfront fees, annual fees, commitment fees, all-in-drawn spread, all-in-undrawn spread, secured status, guarantors, sponsors, top tier arrangers, industry, sales size, Moodys bank and senior debt ratings, and S&P bank and senior debt ratings. We also need to identify the lead lender. However, not all of the deals identify a top tier arranger. Loans missing this field are not suitable for the purposes of this study and were eliminated. This reduces the sample to 27,825 loans. Eliminating loans to financial firms and REITs further reduces the sample to 20,430. We then merge this data with Compustat data. DealScan does not provide the borrowers ticker symbol. Therefore, we match the DealScan and Compustat records by

23

comparing the borrower names in each data set. We were able to match 11,621 loans in DealScan to Compustat. Lender data is compiled from the FDIC call reports from the Federal Reserve Bank of Chicago. We match the top tier lender from DealScan with the bank names in the FDIC database in the year of the loan. We treat observations with multiple lead lenders, non-domestic bank co-leads, and bank holding companies as described above in section 4.3. If the top tier arranger is a finance company, investment bank, or any other financial institution other than a commercial bank we drop these loans from the sample. After matching the FDIC lender data with the merged DealScan/Compustat data, there are 6,056 loans remaining that identify commercial banks as one of their primary lenders. For deals for which there is more than one bank listed as the primary lender the question is: which bank should be treated as the primary lender? We treat each lender as if it is the primary lender for the loan. In this case, the same loan may be in the dataset more than once. This presumes that each lender is chosen in isolation for its ability to monitor.15 Treating each commercial bank named as though it were a separate a primary lender increases the number of records to 6,709. Descriptive statistics for the borrowers and loan rate spreads are presented in Table 5. [Table 5: Descriptive Statistics for Borrower Costs and Characteristics] In Table 5, interest rate information is presented in columns (1) and (2). Column (3), Sales, is a measure of size. The remaining variables are also borrower

characteristics. Panel A presents data for the whole sample. Panels B and C disaggregate the data by lender monitoring ability; Panels D and E disaggregate the data by size.
15

We also conducted the analysis treating the lender listed first in DealScan as the lead lender. We also formed a composite bank as described in section 4.3. The results of these alternative specifications are not materially different from those presented in the text.

24

Firms that borrow from superior monitors are almost 50% larger than firms that do not. Interestingly, both All-In Drawn (AID) spread and Margin are substantially higher (34 and 39 basis points, respectively) for firms that borrow from superior monitoring banks. Furthermore, notice that firms in the superior monitoring sample have lower Altmans Z scores and more accruals. We see similar patterns across small and large borrowers.16 In fact, the interest rate spread differences are particularly dramatic. Lastly, Tobins Q in the large borrower sample is much greater (2.238 vs. 1.838) than in the small borrower sample.17 5.3. Determinants of the All-In Drawn Spread Fama (1985) and James and Smith (2000) conjecture that one benefit of bank monitoring is that it lowers the cost of transacting with other firm claimants (e.g., public debt holders). To address this possibility we would like to control for the likelihood that a firm will be issuing public debt in the future. Denis and Mihov (2003) estimate a

logistic regression that forecasts the probability that a firm will issue bank debt rather than public debt the next time it borrows. Our version of their equation is18: Prob. Public Debt = -1.92 + .14*TA + .01*MV + 1.39*Fixed Asset Ratio + 2.58*Inv. Grade Rating - .52*Not Rated - .17*(Altman's Z < 1.81) - .98*Insider Ownership % + 2.19*Book Leverage As a method for estimating the benefits of bank monitoring for a firms other transactions, this is an admittedly crude procedure. But, the bias of using such a noisy
Altmans Z [Altman (1968)] is computed as: Z =.72*(NWC/TA)+.85*(RE/TA)+3.1*(EBIT/TA) +.42*(SE/TL) +(Sales/TA) 17 Tobins Q is computed here as in Whited (2001). Q = [TA + MV of CS (BV of Equity RE) Deferred Taxes]/TA. 18 TA is total assets of the borrower. MV is the price of the firms equity at year end multiplied by the number of shares outstanding. The fixed asset ratio is the ratio of property, plant, and equipment to total assets. Inv. Grade Rating equals one if the firm has debt rated BBB or higher. Not Rated indicates that the firm has no rated debt. Insider Ownership Percent is collected from Execucomp and is the percent of equity owned by firm management.
16

25

measure is against finding anything. In order to estimate this equation, insider ownership percent was collected from Execucomp. This restriction reduces the sample to 4,534. We modify Denis and Mihovs equation in only one respect. They are examining

specific instances of new issues. Our goal is to estimate the probability associated with the firms next action which has not occurred yet. Therefore, we do not include the size of the current issue in our estimation. Public Debt is our proxy for the monitoring benefits associated with other firm claimants. [Table 6: Determinants of the All-In Drawn Spread] Our main results for this section are presented in Table 6. The dependent variable used in the regressions is the All-In Drawn (AID) spread for each loan.19 AID is

calculated as calculated as provided in the DealScan database and is a measure of the fees and interest earned as a spread above LIBOR. Model (1) regresses AID on Public Debt and borrower control variables suggested by Table 5. Model (2) adds Superior (a dummy equal to 1 if the lender is classified as superior monitor as discussed in 5.1) to the controls used in model (1). Intuitively, the regressions indicate that firms with higher Altmans Z scores pay lower rates. Model (2) tests our main proposition. Firms that borrow from superior monitors pay substantially higher spreads (about 34 basis points on average). As Fama (1985) and James (1987) hypothesized, there is a premium paid for monitoring. This is the first direct evidence that borrowers will pay more for bank monitoring services. Somewhat counterintuitively, in both models (1) and (2) Public Debt is significantly negative. Firms that are more likely to go to the public debt markets pay lower rates. This is counter to the intuition we outlined above that these firms should be
19

Margin was also examined and the results were the same as for all-in drawn spread.

26

willing to pay more to borrow from a superior monitor in order to reduce other contracting costs. This may reflect the greater ability of these borrowers to access the public debt markets already perhaps because they are less risky or better known. In any case, competition from the public debt markets may reduce the rents available to the bank from these borrowers. On the other hand, Johnson (1997b) reports that firms that have public debt outstanding show systematic use of bank debt. consistent with a demand for monitoring services. In models (3) and (4) we attempt to sort this out. In these regressions we limit the analysis to firms ranked above the 75th percentile in Public Debt. In other words, the borrowers in columns three and four are the firms in the sample most likely to enter public debt markets in the future. This restriction reduces the variation in Public Debt, of course. Hopefully, this restriction buys us a sample of firms that are more similar in their current access to the public debt markets. In both models (3) and (4), Superior is positive and highly significant. Moreover, the credit rating variables (Altmans Z and Junk) have the expected signs and are significant. This indicates that among firms that already have some access to the public debt markets, firms that are more likely to enter public debt markets and have poor credit ratings are willing to pay a premium to borrow from a superior monitor. This result is consistent with Famas original intuition and Johnsons (1997b) empirical evidence that bank monitoring reduces contracting costs with the firms other claimants. 5.4 Summary In this section we documented that an index of superior monitoring ability is positively related to loan spreads. We interpret this as evidence that borrowers are He interprets this as

27

willing to pay a premium for monitoring services. This complements Guners (2006) recent finding that loans that are less likely be held by the originating bank command smaller spreads. Our finding indicates that the borrower values an active monitoring relationship that is likely lost when the loan is sold. In addition, monitoring ability appears to be particularly valuable to borrowers with poor credit ratings that are most likely to issue public debt. We interpret this as evidence that bank monitoring reduces contracting costs with other financial claimants.

6.

Concluding Remarks Our goal in this paper was to identify an empirical connection between the banks

are special literature and the why do banks exist? literature. That is, we hoped to identify those characteristics of the bank that allow it to exist (i.e., fill some economic niche not filled by other firms) and that are also related to the evidence that banks are special (bank borrowers will pay a higher rate for these characteristics and these characteristics are associated with higher abnormal returns). The short answer is that banks exist because they are specialized monitors. The monitoring services that banks provide are valuable. Borrowers pay a premium to lenders who possess identifiable monitoring skill and the market rewards borrowers who borrow from lenders who possess identifiable monitoring skill. Thus, the gains from monitoring appear to be shared

between the lender (monitor) and the borrower. In this paper we directly related the positive abnormal returns associated with bank loan announcements to the borrowers willingness to pay higher loan yield spreads. The bond that connects these benefits and costs associated with bank monitoring is a small set of proxies for the banks monitoring ability (or incentives to monitor). We show

28

that these lender characteristics are positively related to higher excess returns surrounding bank loan announcements. Moreover, an index of superior monitoring ability based on these factors is positively related to the loan yield spreads paid by bank borrowers. By showing that the same monitoring variables are related to both the announcement returns and borrower rate spreads we provide the most comprehensive evidence to date that what is different about banks is that they are active monitors. Thus, the answer (or at least an important piece of the answer) to the general question, why do banks exist? is also the answer to the specific question initially raised by Fama (1985) and James (1987), whats different about banks? The proxies that are related to both abnormal announcement returns and borrower spreads are 1) the ratio of the banks uninsured deposits to total loans, 2) a risk-adjusted measure of recovered charge offs , and 3) the banks capital ratio. Prior theoretical work by Calomiris and Kahn (1991) and Diamond and Rajan (2001) argued that uninsured demand deposits improve the banks incentives to monitor borrowers. We provide the first empirical documentation of this benefit of uninsured demand deposits. Finally, the first two proxies are strikingly consistent with the theory of banking laid out in Diamond and Rajan (2001). In their model, the banks specialized monitoring skill manifests itself through higher liquidation (or collateral) values for the borrowers assets. However, uninsured depositors are crucial to providing the bank with the proper incentives to deploy this skill efficiently. They argue that these two bank characteristics monitoring skill and fragile deposits must co-exist. Our results indicate that for the best bank monitors they do.

29

Our research design is predicated on the assumption that we can identify lenders with greater monitoring ability and/or incentives to monitor. This framework suggests several avenues for future research. Perhaps the most natural extension is to ask whether or not loan contracts also differ along non-price dimensions? For example, do superior monitors rely on fewer explicit covenants or make longer term loans? A second question that can be addressed within our framework is what are the characteristics of borrowers that choose superior monitors? Our intuition is that they will be smaller, more

informationally opaque firms. A related question revolves around the decision to switch lenders. Do borrowers that change lenders pay more to switch to better monitors or do they pay less as they graduate to less intensive monitors? Gopalan, Udell, and

Yerramilli (2007) report that borrowers appear to graduate to less constrained lenders as their information environment improves. They do not find any significant changes in the rates paid by borrowers after they move to a new lender. However, they do not include any controls for monitoring ability. So, the influence that monitoring ability has on the decision to switch lenders is still an open question. Finally, our research design explicitly assumes that some lenders are weaker monitors than others. What services do they provide that allows them to remain solvent? Introduction is confidentiality. One possibility mentioned in the

The confidentiality hypothesis is a complementary

explanation for the positive abnormal returns associated with bank loan announcements. Banks facilitate the shielding of strategic information from the borrowers competitors, but simultaneously certify to the market that the borrower has good prospects via the act of extending credit. It may be possible to confirm this certification effect by examining

30

the impact of bank loan announcements on the borrowers competitors. We plan to address this question in future research.

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Calomiris, Charles W. and Kahn, Charles M. The Role of Demandable Debt in Structuring Optimal Banking Arrangements. The American Economic Review 81 (1991): 497-513. Campbell, Tim S. Optimal Financing Decisions and the Value of Confidentiality. Journal of Financial and Quantitative Analysis 14 (1979): 913-24. Chan, Yuk-Shee. On the Positive Role of Financial Intermediation in Allocation of Venture Capital in a Market with Imperfect Information. The Journal of Finance 38 (1983): 1543-1568. Cook, D. O., C. D. Schellhorn, and L. J. Spellman, Lender Certification Premiums, Journal of Banking and Finance 27 (2003), 1561-79. Dahiya, Sandeep, Manju Puri, and Anthony Saunders, Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans, Journal of Business 76 (2003), 563-82. Denis, David J. and Mihov, Vassil T. The choice among bank debt, non-bank private debt, and public debt: evidence from new corporate borrowings. Journal of Financial Economics 70 (2003): 3-28. Diamond, Douglas. Financial Intermediation and Delegated Monitoring. Review of Economic Studies 51 (1984): 393-414. Diamond, Douglas. Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt. Journal of Political Economy 99 (1991): 689-721. Diamond, Douglas W. and Rajan, Raghuram G. Liquidity risk, liquidity creation and financial fragility: A theory of banking. Journal of Political Economy 109 (2001): 287-327. Fama, Eugene F. Whats Different about Banks? Journal of Monetary Economics 15 (1985): 29-39. Flannery, Mark J., Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence, Journal of Money, Credit, and Banking 30 (1998), 273-305. Goldberg, Lawrence G., and Sylvia C. Hudgins, Response of Uninsured Depositors to Impending S&L Failures: Evidence of Depositor Discipline, The Quarterly Review of Economics and Finance 36 (1996), 311-25. Goldberg, Lawrence G., and Sylvia C. Hudgins, Depositor Discipline and Changing Strategies for Regulating Thrift Institutions, Journal of Financial Economics 63 (2002), 263-74.

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Gopalan, Radhakrishnan, Gregory F. Udell, and Vijay Yerramilli, Why Do Firms Switch Banks? Working paper. Indiana University (2007): 1-42. Guner, A. Burak, Loan Sales and the Cost of Corporate Borrowing, forthcoming, Review of Financial Studies (2006). Hadlock, Charles J. and James, Christopher M. Do Banks Provide Financial Slack? The Journal of Finance 57 (2002): 1383-1419. Holmstrom, Bengt and Tirole, Jean. Financial Intermediation, Loanable Funds, and the Real Sector. The Quarterly Journal of Economics 112 (1997): 663-691. Hubbard, R. Glenn, Kenneth N. Kuttner, and Darius N. Palia, Are There Bank Effects in Borrowers Costs of Funds? Evidence from a Matched Sample of Borrowers and Banks, Journal of Business 75 (2002), 559-581. James, Christopher. Some Evidence on the Uniqueness of Bank Loans. Journal of FinancialEconomics 19 (1987): 217-235. James, Christopher, and David C. Smith, Are Banks Still Special? New Evidence on Their Role in the Corporate Capital-Raising Process, Journal of Applied Corporate Finance 13 (2000), 52-63. Johnson, Shane A. The Effect of Bank Reputation on the Value of Bank Loan Agreements. Journal of Accounting, Auditing, and Finance 12 (1997a): 83-100. Johnson, Shane A. An Empirical Analysis of the Determination of Corporate Debt Ownership Structure. Journal of Financial and Quantitative Analysis 32 (1997b): 47-69. Kane, Edward J., and Burton G. Malkel, Bank Portfolio Allocation, Deposit Variability, and the Availability Doctrine, Quarterly Journal of Economics 79 (1965), 25761. Kim, Moshe, Eirik Gaard Kristiansen, and Bent Vale, Endogenous Product Differentiation in Credit Markets: What Do Borrowers Pay For? Journal of Banking and Finance 29 (2005), 681-99. Lee, Kwang-Won and Sharpe, Ian G. Does the Banks Monitoring Ability Matter? Working Paper, University of New South Wales (2004): 1-33. Lummer, Scott L. and McConnell, John J. Further Evidence on the Bank Lending Process and the Capital Market Response to Bank Loan Agreements. Journal of Financial Economics 25 (1989): 99-122.

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34

Table 1 Characteristics of Bank Loan Announcements This table reports summary statistics for the sample of 478 bank loan announcements made during1988-1996. The Loan Amount includes the amount drawn down immediately as well as the unused portion of the line. Borrower Size is defined as the sum of the book value of total liabilities, liquidating value of preferred stock, and the market value of common stock as of end of the year prior to the announcement. Loan/MV Equity is the dollar amount of the loan divided by the market value of the borrowers assets. In the sample with lender FDIC data available, 217 of 423 announcements did not provide the Loan Maturity. Firms are deemed to have Public Debt outstanding if Compustat reports a debt rating at the end of the year prior to the announcement or if Compustat reports a non-zero balance for public debt for the prior year. The 10-day Cumulative Stock Return is measured in the ten days preceding the announcement and the Stock Return Volatility is measured from day -200 to day -51 before the announcement. Means are reported with medians in parentheses below. Panel A: Full Sample of Loan Announcements N = 478; N = 112 w/Public Debt Mean Max Min Loan Amount ($ millions) 102.0 2,050.0 0.5 (40.0) Borrower Size ($ millions) 533.9 (130.4) 1.56 (0.51) 3.1 (3.0) 8,567.3 1.6

Loan / MV of Equity

348.4

0.02

Loan Maturity (in years)

10.0

0.1

Loan Amount ($ millions) % with Multiple Lead Banks Borrower Size ($ millions)

Panel B: Announcements with FDIC Lender data available N = 423; N = 99 w/Public Debt Mean Max Min 98.7 2,050.0 0.5 (40.0) 47.75% 460.9 (131.2) 0.78 (0.50) 3.2 (3.0) 1.09% (0.0%) 7.84% (3.59%) 8,567.3 1.6

Loan / MV of Equity

8.2

0.02

Loan Maturity (in years)

10.0

0.1

10-day Cumulative Stock Return Stock Return Volatility

69.697%

-41.67%

811.08%

0.99%

Table 2 Two-day Standardized Prediction Errors

This table reports the 2-day standardized prediction errors for the whole sample and stratified by various lender characteristics. Two-day excess returns are calculated using the market model where the two day period includes the day of the announcement and the day following the announcement. Initially, 478 loans were in the sample but 55 firms were lost due to a lack of lender information leaving a sample of 423 loans. The t-statistic is the result of testing if the average standardized prediction error is significantly different from zero except for the t-stats for the rows labeled Difference. The t-stats in the rows labeled Difference are tests for significance between the mean for the portion of the sample above the mean less the mean of the sample below the median in a given sample. * Indicates significant at the 10% level, ** indicates significance at the 5% level and *** indicates significant at the 1% level. The sample for this study is composed of loan announcements by non-financial and non-REIT firms. The announcements are from the period from 1988-1996, and there collected using Factiva where the search was conducted on Dow Jones Newswires and Reuters wires, as well as the Wall Street Journal. Announcements were checked for contaminating events on the day of, the day before, and the day after the announcement. This search was performed using Factiva for any print or wire article. Uninsured Deposits is the highest ratio of total deposits over $100K to total loans among the lead banks for the firm. Capital Ratio is the highest ratio of the capital ratio of the bank to the capital ratio of the firm among the lead banks for the firm. Loan Yield is the highest ratio of fee and interest income on C&I loans to the dollar amount of C&I loans among the lead banks for the firm. Recovered Charge Off% is the highest ratio of dollar amount of recoveries by the bank to dollar amount of charge-offs. Past Due Loans/Assets is the trailing three year average of past due and accrual loans divided by total assets. LC/Bank Assets is the highest ratio of loan commitments outstanding to the total assets among the lead banks for the firm.

Whole Sample By Lender Characteristic Defaulted Loan Recovery Recovered Charge Off% Above Median Below Median Difference Past Due Loan/Assets (PDLA) Above Median Below Median Difference Recovered Charge Off%*PDLA Above Median Below Median Difference Capital Ratio Above Median Below Median Difference

Two-day Number of Excess Observations Returns 478 0.91% 423 0.89%

Percent of Positive Excess t-stats Returns 3.11*** 54.60% 3.03*** 54.85%

211 212

0.94% 0.83% 0.11%

2.01** 2.36** 0.19

56.40% 53.30%

210 213

1.30% 0.48% 0.82%

2.73*** 55.14% 1.40 55.24% 1.40

209 214

1.11% 0.67% 0.44%

2.36** 1.90* 0.76

54.55% 55.14%

212 211

0.81% 0.97% -.16%

2.37** 2.02** -.27

58.02% 51.66%

36

Uninsured Deposits Above Median Below Median Difference Loan Yield Loan Yield Above Median Below Median Difference Yields*PDLA Above Median Below Median Difference LC/Bank Assets Above Median Below Median Difference

211 212

1.45% 0.33% 1.12%

2.91*** 57.82% 51.87% 1.08 1.91*

212 211

0.88% 0.90% -.02% 1.29% 0.49% 0.80%

2.32** 2.00** -.04

55.19% 54.50%

210 213

2.71*** 55.71% 53.99% 1.43 1.36

212 211

0.92% 0.85% 0.07%

2.28** 2.00** 0.12

56.60% 53.08%

37

The Number of Prediction Errors by Category 100 120 20 40 60 80 0

Figure 1: Distribution of Two-Day Standardized Prediction Errors

Two-Day Prediction Errors

<-20.5% -20.5% to -19.5% -19.5% to -18.5% -18.5% to -17.5% -17.5% to -16.5% -16.5% to -15.5% -15.5% to -14.5% -14.5% to -13.5% -13.5% to -12.5% -12.5% to -11.5% -11.5% to -10.5% -10.5% to -9.5% -9.5% to -8.5% -8.5% to -7.5% -7.5% to -6.5% -6.5% to -5.5% -5.5% to -4.5% -4.5% to -3.5% -3.5% to -2.5% -2.5% to -1.5% -1.5% to -0.5% -0.5% to 0.5% 0.5% to 1.5% 1.5% to 2.5% 2.5% to 3.5% 3.5% to 4.5% 4.5% to 5.5% 5.5% to 6.5% 6.5% to 7.5% 7.5% to 8.5% 8.5% to 9.5% 9.5% to 10.5% 10.5% to 11.5% 11.5% to 12.5% 12.5% to 13.5% 13.5% to 14.5% 14.5% to 15.5% 15.5% to 16.5% 16.5% to 17.5% .175 to .185 18.5% to 19.5% 19.5% to 20.5% >20.5%

Table 3 Characteristics of Proxies for Bank Monitoring

This table reports the mean values for each of the tested monitoring proxies (with medians below). Uninsured Deposits is the highest ratio of total deposits over $100K to total loans among the lead banks for the firm. Capital Ratio is the highest ratio of the capital ratio of the bank to the capital ratio of the firm among the lead banks for the firm. Loan Yield is the highest ratio of fee and interest income on C&I loans to the dollar amount of C&I loans among the lead banks for the firm. Recovered Charge Off% is the highest ratio of dollar amount of recoveries by the bank to dollar amount of charge-offs. Past Due Loans/Assets is the trailing three year average of past due and accrual loans divided by total assets. LC/Bank Assets is the highest ratio of loan commitments outstanding to the total assets among the lead banks for the firm. Loan Loss Provision is the lowest ratio of the allowance for loan and lease losses to the gross dollar amount of loans and leases among the lead banks for the firm. Full Sample N = 423 Mean Max Min 0.38801 3.53115 0.017486 Uninsured Deposits (0.34350) Capital Ratio 0.37555 (0.1975) 0.053693 (0.052055) 0.63642 (0.32895) 0.032721 (0.011005) 0.000706 (0.0000007) 0.025992 (0.022947) 49.8102 -25.1106

0.21053

0.026946

Loan Yield Recovered Charge Off %

14.7731

Past Due Loans / Assets

2.00868

LC / Bank Assets

0.0244832

Loan Loss Provision

0.11799

Table 4 The Effect of Lender Monitoring Incentives on Borrower Equity Returns

This table reports results of cross-sectional regressions of abnormal loan returns on lender characteristics, specifically yit = 0 + 1Xit + Controls. yit is the 2-day excess return of a bank loan announcement, X represents bank monitoring proxies, and Controls are borrower characteristics and contract terms . Uninsured Deposits is the highest ratio of total deposits over $100K to total loans among the lead banks. Capital Ratio is the highest ratio of the capital ratio of the bank to the capital ratio of the firm among the lead banks. Loan Yield is the highest ratio of fee and interest income on C&I loans to the dollar amount of C&I loans among the lead banks. Recovered Charge Off% is the highest ratio of dollar amount of recoveries by the bank to dollar amount of charge-offs. Past Due Loans/Assets is the trailing three year average of past due and accrual loans divided by total assets. LC/Bank Assets is the highest ratio of loan commitments outstanding to the total assets among the lead banks. Recovered*Past Due is an interaction term of Recovered Charge Off% and Past Due Loans/Assets. Loan Yield*Past Due is an interaction term of Loan Yield and Past Due Loans/Assets. Log (MV Equity) is the log of the market value of the borrowers equity. Run Up is the 10 day cumulative stock return measured for ten days preceding the announcement and Stock Return Volatility is measured from days -200 to -51 before the announcement. Public Debt Dummy is one if the borrower has public debt and zero otherwise. Loan Size/MV Equity is the ratio of the size of the loan in dollars to the market value of the borrower in dollars. Maturity is the maturity of the loan in years taken by the borrower. (1) Intercept Bank Monitoring Proxies Uninsured Deposits Capital Ratio Past Due Loans / Assets Recovered Charge Off % Recovered*Past Due Loan Yield Loan Yield*Past Due LC / Bank Assets Borrower Characteristics Log (MV Equity) Run Up Stock Return Volatility Public Debt Dummy Contract Terms Loan Size / MV Equity Maturity # of Announcements Adjusted R2 423 0.0459 0.106 [0.38] 0.289 [1.86] 0.042 [2.75] 0.593 [0.08] -0.067 [1.80] 0.409 [1.91] -2.378 [0.53] -49.522 [0.32] 11.368 [0.56] (2) 0.275 [0.73] 0.303 [1.89] 0.042 [2.75] 0.784 [0.10] -0.069 [1.85] 0.377 [1.76] -3.019 [0.54] -50.906 [0.32] 9.599 [0.47] -0.031 [0.98] -1.161 [2.67] 0.024 [0.29] 0.033 [0.30] 0.041 [0.79] 0.024 [1.07] 423 0.0687 (3) 0.041 [0.54] 0.318 [2.16] 0.043 [2.87] (4) big 1.199 [0.89] -0.805 [1.20] 0.053 [2.85] -5.618 [0.25] -0.065 [0.40] 5.967 [0.54] -14.444 [1.09] 46.351 [0.11] 213.311 [1.45] -0.090 [0.70] -2.745 [2.39] 9.175 [0.69] 0.449 [1.80] 0.246 [0.98] 0.008 [0.21] 82 0.3564 (5) small 0.195 [0.41] 0.376 [2.20] -0.003 [0.10] -0.829 [0.09] -0.075 [1.73] 0.446 [0.87] -2.286 [0.33] -21.422 [0.12] 5.938 [0.27] -0.025 [0.52] -0.967 [2.02] 0.023 [0.27] -0.034 [0.28] 0.043 [0.78] 0.037 [1.33] 341 0.0486

-0.068 [1.88] 0.404 [2.20]

-36.545 [2.79]

-1.05146 [2.61]

423 0.0593

40

Table 5 Descriptive Statistics for Borrower Costs and Characteristics This table reports summary statistics for various borrower costs and characteristics. All-in drawn spread (AID) and Margin are measured in basis points. Margin for variable rate loans above either the bank's prime rate or LIBOR. Nearly all loans in the sample were variable rate loans and not fixed rate loans. Sales are sales of the borrower in millions of dollars. In this paper, Sales is used as a proxy for firm size. Altman's Z is computed as follows: Z = .72*(NWC/TA) + .85*(RE/TA) + 3.1*(EBIT/TA) + .42*(SE/TL) + Sales/TA. Z is a prediction of whether or not a firm will go bankrupt. The lower the value the more likely the firm is to go bankrupt. According to Altman, firms with a score less than 1.2 are predicted to go bankrupt while firms with scores between 1.2 and 2.9 were teetering between recovery and decline. Tobins Q is computed as [TA + MV of CS - (BV of Equity - RE) - Deferred Taxes]/TA. Q is a measure of a firm's prospects. More specifically, it is a measure of the value of a firm's assets relative to their replacement cost. Leverage is measured as total liabilities divided by total assets. Deal Size is the size of the loan deal relative to firm size as measured by Sales. R&D Expense is a measure of research and development expense relative to Sales. Accruals is a ratio of accrued expenses to cost of goods sold. Fixed to Total Assets is the ratio of property, plant and equipment to total assets. Panel (b) contains the descriptive statistics for borrowers who borrow from superior monitoring banks. Superior monitors are those above the median in the two of the following three ratios: 1) Deposits over $100K to total loans, 2) Recovered loans to charged off loans adjusted for risk measured by past due and nonaccrual loans, and 3) the banks ratio of capital to total assets. Panel (c) contains descriptive statistics for all borrowers whose lender does not fit the superior monitor criteria. Panel (d) contains descriptive statistics for borrowers whose size is above the mean when measured by Sales. Panel (e) contains descriptive statistics for borrowers whose size is below the mean when measured by Sales. a. All Borrowers in the Sample (n = 6,709) Fixed to R&D Total Margin AID Sales Altmans Z Tobins Q Leverage Deal Size Accruals Expense Assets Mean 162.785 165.385 $3,793.94 2.114 1.956 0.605 0.34045 0.058 0.127 0.345 Std. Dev. 146.830 125.645 $9,106.700 1.641 2.308 0.251 1.04337 1.073 0.282 0.228 Max 4,625.000 1,080.000 $187,510.000 30.509 105.126 3.886 50.00000 71.949 8.902 0.968 Min 0.000 10.000 $0.016 -16.696 -9.591 0.014 0.00004 0.000 0.000 0.000 b. Borrowers in the Sample Associated with Superior Monitoring Banks (n = 3,635) R&D Expense 0.048 0.376 12.626 0.000 Fixed to Total Assets 0.336 0.228 0.946 0.001

Mean Std. Dev. Max Min

Margin 180.211 165.591 4,625.000 9.000

AID 181.143 132.883 1,080.000 12.000

Sales $4,439.350 $10,556.510 $187,510.000 $0.159

Altmans Z 1.974 1.627 16.264 -16.696

Tobins Q 1.953 3.292 105.126 -2.743

Leverage 0.615 0.250 2.818 0.023

Deal Size 0.32854 0.62041 50.00000 0.00004

Accruals 0.139 0.299 8.902 0.000

c. Borrowers in the Sample Associated with Non-superior Monitoring Banks (n = 3,074) R&D Expense 0.070 1.533 71.949 0.000 Fixed to Total Assets 0.355 0.227 0.968 0.000

Mean Std. Dev. Max Min

Margin 141.923 117.259 975.000 0.000

AID 146.579 113.618 775.000 10.000

Sales $3.030.740 $6,938.760 $100,697.000 $0.016

Altmans Z 2.280 1.717 30.509 -13.813

Tobins Q 1.958 1.653 33.285 -9.591

Leverage 0.593 0.251 3.886 0.014

Deal Size 0.35447 0.96185 28.49000 0.00045

Accruals 0.114 0.259 8.902 0.000

d. Borrowers in the Sample Smaller than the Mean (n = 5,269) R&D Expense 0.068 1.210 71.949 0.000 Fixed to Total Assets 0.337 0.237 0.968 0.000

Mean Std. Dev. Max Min

Margin 190.050 149.684 4,625.000 0.000

AID 191.023 124.100 1,080.000 12.500

Sales $825.464 $905.411 $3,789.670 $0.016

Altmans Z 2.076 1.751 30.509 -16.696

Tobins Q 1.878 2.489 105.126 -9.591

Leverage 0.588 0.266 3.886 0.014

Deal Size 0.40451 1.16803 50.00000 0.00045

Accruals 0.129 0.295 8.902 0.000

e. Borrowers in the Sample Larger than the Mean (n =1,440) R&D Expense 0.021 0.038 0.272 0.000 Fixed to Total Assets 0.374 0.191 0.935 0.032

Mean Std. Dev. Max Min

Margin 63.608 77.108 905.000 9.000

AID 71.759 77.679 605.000 10.000

Sales $14,655.660 $7,987.770 $187,510.000 $3,797.200

Altmans Z 2.253 1.142 8.495 -1.279

Tobins Q 2.238 2.064 16.904 0.426

Leverage 0.667 0.170 2.414 0.203

Deal Size 0.33947 1.15173 50.00000 0.00004

Accruals 0.122 0.226 3.230 0.000

42

Table 6 Determinants of the All-in Drawn Spread (AID)

This table reports the results of a cross-sectional regression of borrower costs on lender characteristics. Specifically, we estimate yit = 0 + 1Xit + Controls, where y is All-In Drawn Spread and X represents lender monitoring ability, and Controls are borrower characteristics. Superior is a dummy variable that equals one if the lender is a superior monitor. Public Debt is a continuous variable that indicates the likelihood that the firm will issue public debt when it next uses debt financing. The variable is generated using an equation from Denis and Mihov (2003) where the dependent variable is the log odds ratio of the probability of issuing public debt relative to bank debt. The only difference in the calculation is that we do not include the amount issued since we are not looking at a specific issue for the borrower. The equation is Public Debt = -1.92 + .14*TA + .01*MV + 1.39*Fixed Asset Ratio + 2.58*Inv. Grade Rating - .52*Not Rated - .17*(Altman's Z < 1.81) - .98*Insider Ownership Percent + 2.19*Book Leverage. Accrue is a ratio of accrued expenses to cost of goods sold. Altman's Z is computed as follows: Z = .72*(NWC/TA) + .85*(RE/TA) + 3.1*(EBIT/TA) + .42 (SE/TL) + Sales/TA. Z is a prediction of whether or not a firm will go bankrupt. The lower the value the more likely the firm is to go bankrupt. According to Altman, firms with a score less than 1.2 are predicted to go bankrupt while firms with scores between 1.2 and 2.9 were teetering between recovery and decline. Current assets to total assets, CA/TA, is a measure of firm liquidity. FA/TA is the ratio of fixed assets to total assets. Junk indicates the borrower has a debt rating of below BBB. All models include control variables for industry type. The models in columns (3) and (4) were performed with firms with a Public Debt value above the 75th percentile. These borrowers are the most likely to go to the market in the future.

Intercept

Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value Coefficient P-Value N

Dependent Variable = AID (1) (2) (3) 181.6524 165.3300 130.3984 <.0001 <.0001 <.0001 33.8660 <.0001 -21. <.0001 -1.5447 0.8142 -18.6893 <.0001 100.4883 <.0001 9.1306 0.4245 -1.6484 0.7247 4,534 -22.1179 <.0001 -3.5871 0.5811 -18.2557 <.0001 113.5534 <.0001 24.1733 0.0339 -5.6419 0.2247 4,534 1,126 14.4786 0.0151

(4) 86.2052 0.0113 11.6454 0.0384

Superior

Public Debt

Accrue

10.1222 0.2193 -30.7844 <.0001 174.2731 <.0001 83.8746 <.0001 52.9284 <.0001 1,126

Altmans Z

CA/TA

FA/TA

Junk