Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests

52 Pages Posted: 26 Nov 2011 Last revised: 16 May 2024

See all articles by B. Espen Eckbo

B. Espen Eckbo

Tuck School of Business at Dartmouth; European Corporate Governance Institute (ECGI)

Xunhua Su

Norwegian School of Economics (NHH)

Karin S. Thorburn

Norwegian School of Economics; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Multiple version iconThere are 2 versions of this paper

Date Written: May 12, 2024

Abstract

Unlike corporate bonds, commercial bank loans typically allow the borrower to prepay the loan without penalty (a zero cancellation fee). We present a novel theoretical and empirical analysis of how banks must be compensated for this penalty-free prepayment option. In our model, after loan origination, borrowers receive non-contractible information about the value of the project funded by the bank loan. This dynamic learning causes some ex post high-value borrowers to prepay or renegotiate the loan to obtain a lower rate, deteriorating the overall credit-quality of the bank's borrower pool. We show that, to avoid credit rationing of high prepayment-risk borrowers, the bank must be compensated with a minimum upfront fee rather than increasing the initial loan rate. Intuitively, an upfront fee dominates a cancellation fee that risks costly ex post bargaining with the bank's high-value clients. Large-sample tests confirm that upfront fees increase with borrower prepayment risk and are lower in credit lines and loans with performance-sensitive pricing, as predicted. The tests employ a prepayment-risk index, which contains proxies for borrower upside potential and loan renegotiation costs, constraining the variables to enter with their predicted sign. The inferences are robust to using industry-level M&A activity as instrument for exogenous variation in prepayment risk and a two-step estimation procedure controlling for self-selection in fee reporting. The tests confirm that the upfront fee is the only fee that can compensate for the penalty-free prepayment option.

Keywords: bank loans, prepayment, credit rationing, upfront fee, performance-pricing

JEL Classification: D82, D86, G21, G32

Suggested Citation

Eckbo, B. Espen and Su, Xunhua and Thorburn, Karin S., Bank Compensation for the Penalty-Free Loan-Prepayment Option: Theory and Tests (May 12, 2024). Tuck School of Business Working Paper No. 1964843, European Corporate Governance Institute – Finance Working Paper No. 770/2021, Available at SSRN: https://ssrn.com/abstract=1964843 or http://dx.doi.org/10.2139/ssrn.1964843

B. Espen Eckbo (Contact Author)

Tuck School of Business at Dartmouth ( email )

Hanover, NH 03755
United States
603-646-3953 (Phone)
603-646-3805 (Fax)

HOME PAGE: http://tuck.dartmouth.edu/faculty/faculty-directory/b-espen-eckbo

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Xunhua Su

Norwegian School of Economics (NHH) ( email )

Helleveien 30
Bergen, NO-5045
Norway

HOME PAGE: http://sites.google.com/site/xunhuasu/

Karin S. Thorburn

Norwegian School of Economics ( email )

Helleveien 30
N-5045 Bergen
Norway
+4755959283 (Phone)

HOME PAGE: http://www.nhh.no/cv/thorburn

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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