The Finance Brown Bag Seminar is held by the Institute for Finance, Banking and Insurance (WU Vienna) and the Vienna Graduate School of Finance (VGSF). It serves as a presentation platform for PhD students, faculty members, and visitors. An overview of BBS on the website of the Institute for Finance, Banking and Insurance.
Karin Thorburn, NHH Norwegian School of Economics
Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests
(with B. Espen Eckbo and Xunhua Su)
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.