Information Asymmetry, Line of Credit and Term Loan Pricing

Abstract:     
Majority of the term loans in US are made to the firms that also hold the line of credit or they are packaged with the line of credit. In my study, I am focusing on the information effect of the line of credit. According to my hypothesis, line of credit may facilitate banks collect more information on the financial health of the firm and ease out some of the information asymmetry prevalent in borrower-lender relationship. This information should be beside the usual accounting data available about the firm on the measures of financial constraint and financial distress. I have found statistically significant evidence that banks use the line of credit information in making term lending decision and this finding is consistent after controlling for various firm characteristics. After controlling for observable characteristics of line of credit available at the time of securing the line of credit, the information effect persists, which leads to the following explanation. There can be some mitigation in information asymmetry that takes place over time wherein banks observe the firm’s activity through the line of credit usage, timely paybacks and compliance with hard and soft covenants of credit contract. However, there is no such evidence of information effect when firm obtains the term loan and line of credit in the same year as a part of a deal, which supports the information collection over time. The study also shows that the firms vary on the scale of information asymmetry, hence the association between the information from the line of credit and term loan pricing is contingent on the degree of asymmetry and the potential of the line of credit being a monitoring channel. Finally, the study also documents the negative externality of the banking relationship if the firms holding lines of credit issue debt securities like bonds or notes.

Keywords: Line of Credit, Term Loan, Information Asummetry, Private Information, Credit History, Heckman Estimator

JEL Classification: G21, G32, D82

working papers series