Penalty-free Prepayment and Upfront Fees in Bank Loans

Abstract

Corporate term loans typically include a penalty-free prepayment option. In a model where borrowers strategically prepay, we show that high prepayment risk can trigger credit rationing by the bank. However, an upfront fee, which allows the bank to lower the loan spread and therefore the prepayment risk, restores an equilibrium with funding. Large-sample tests reveal that upfront fees are positively associated with proxies for loan prepayment risk and lower for performance-sensitive debt, as the theory predicts. Higher prepayment risk caused by exogenous merger activity in the industry of the borrower also increases upfront fees as predicted.

Keywords: credit rationing, upfront fee, borrower risk, performance-pricing, security, collateral

JEL Classification: D82, D86, G21, G32