Why does a CFO need to worry about her company’s access to a legally binding bank line of credit? Maybe bank lines of credit are not as committed as they seem, and maybe there are times when a borrower needs to worry about a lender’s credit rating. Koeppel was not alone. Mark Shamber (CFO of United Natural Foods, which has a $400 million credit facility with banks) reportedly “now carefully tracks the financial reports of the publicly traded members of his bank group.”
A formal credit line (sometimes known as a revolving credit facility or a loan commitment) is a legally binding commitment for which a bank has charged a fee, which allows the borrower to take down funds at a certain spread over a base rate. Bank lines of credit and cash holdings are the two most popular liquidity management tools used by corporations (Lins, Servaes, and Tufano, 2007). Sufi (2007) finds that 85% of firms in his sample obtained a line of credit between 1996 and 2003, and the line of credit represents an average of 16% of book assets. In Lins et al.’s (2007) international sample, the median line of credit is equal to 15% of book assets, whereas cash holdings comprise only 9% (among which only 40% are not tied up for day-to-day operations).
The theoretic literature considers lines of credit as committed liquidity insurance (Boot, Thakor, and Udell, 1987; Berkovitch and Greenbaum, 1991; Duan and Yoon, 1993; Holmstrom and Tirole, 1998; Morgan, 1994; Shockley, 1995; and Thakor, 2005). The literature also shows that depository banks have a natural advantage in providing liquidity under lines of credits (Kashyap, Stein, and Rajan, 2002; Gatev and Strahan, 2006, 2008; Nini, 2008; Gatev, Schuermann, and Strahan, 2009).
However, the empirical literature on corporate cash holdings finds that firms, and in particular smaller firms, rely a lot on cash for liquidity management (Almeida, Campello, and Weisbach, 2004; Faulkender and Wang 2006; Opler et al. 1999; Duchin, Ozbas, Sensoy, 2008), suggesting that lines of credit do not provide sufficient liquidity insurance for all firms. Sufi (2007) finds that banks provide credit lines that are contingent on maintenance of cash flow and that lines of credit are therefore a poor liquidity substitute for firms that have low existing or expected cash flows.
In this paper we provide an additional explanation as to why bank lines of credit are contingent but not committed sources of liquidity insurance for certain types of firms. Specifically, we show that provision of credit in committed lines of credit is sensitive also to the banks’ own financial conditions. At first sight, precommitted credit lines provide committed insurance for borrowers because both credit limits and terms are set ex-ante and they are legally binding promises. However, we believe that banks can exploit at least two sources of bargaining power to influence credit line takedown volumes.
Download
How Committed Are Bank Lines of Credit? Experiences in the Subprime Mortgage Crisis
