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.
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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.
