Two-part pricing of corporate bank loans with penalty-free prepayment

Abstract

Corporate bank loans typically include the option to prepay the loan without penalty. In a two-part loan-pricing model with dynamic learning, where ex post high-quality borrowers optimally prepay, we show that an upfront fee in combination with a lower loan spread resolves credit rationing for borrowers with high risk of prepayment. As predicted, large-sample evidence, which includes exogenous industry-level variation in loan prepayment risk, confirms that upfront fees are increasing in prepayment risk. We also discuss loans with performance-sensitive pricing, and why banks may prefer the penalty-free prepayment option over a cancellation fee.

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

JEL Classification: D82, D86, G21, G32