Upfront Fees and Prepayment Risk in Bank Loans

Abstract

Commercial and industrial term loans typically allow the borrow to prepay the loan without penalty. We develop and test a simple theoretical framework in which ex-post high-quality firms strategically prepay after receiving a private non-contractible signal about investment project quality. In the model, the prepayment option may triggers credit rationing unless the bank charges an upfront fee. Large-sample empirical tests show that upfront fees increase with prepayment risk, which is consistent with the model prediction. Furthermore, we show that upfront fees are higher after an exogenous shock to prepayment risk (instrumented with industry merger activity) and lower for performance-sensitive debt and credit lines, also as predicted by our model framework.

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

JEL Classification: D82, D86, G21, G32