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Bank Loans, Bonds, and Information Monopolies across the Business Cycle

The idea that there are both costs and benefits to relying on bank debt is an integral part of the modern theory of corporate finance. As formulated by Rajan (1992), the pros and cons are as follows. Being relatively concentrated, bank debt has more incentive to monitor the borrower than does dispersed “arm’s length” debt. But then the private information which the bank gains through monitoring allows it to “hold up” the borrower if the borrower seeks to switch to a new funding source, it is pegged as a lemon regardless of its true financial condition.

In this paper, we seek empirical evidence for this informational hold-up effect by contrasting the pricing of bank loans for bank-dependent borrowers with the pricing of bank loans for borrowers with access to public debt markets. Our evidence suggests that these costs do exist and are economically significant.

Previous work on this topic has focused on firms’ choice of funding. Thus, a large literature has looked at whether firms that depend on banks seek one or more bank relationships, arguing that reliance on a single bank implies that the benefits of a single bank outweigh the informational costs, whereas reliance on multiple banks suggests the opposite. Empirical results in this area are mixed; we discuss some of this literature below.

Our paper takes a different approach, focusing on how the pricing of bank loans varies across the business cycle for firms that are more or less dependent on private finance. We begin with Rajan’s (1992) theoretical prediction that firms with a higher probability of failure should suffer more from informational hold-up problems; intuitively, such firms are riskier, making the lemons problem that leads to hold-up more significant. Since firms are typically in greater danger of failure during recessions, it follows that, during recessions, banks that have an exploitable information advantage should be able to raise their rates by more than is justified by increased borrower default risk alone.

Bank Loans, Bonds, and Information Monopolies across the Business Cycle