Does Bank Monitoring Matter to Bondholders?

Abstract

In this paper, we examine the existence of a cross-monitoring effect between bank debt and public debt by exploring the effects that loan defaults have on the lead arranger’s perceived monitoring ability in the public debt markets. Generating a sample of major loan defaults among U.S. firms between 2002 and 2010, we empirically test the effects that these loans had on the bond returns of publicly traded firms that had existing loans made by the same lead lender as the defaulting firm. We show that the abnormal returns of these “affected firms” are negative and statistically significant. Moreover, these abnormal returns are economically significant – with a mean about -1% when measured over an eleven day window surrounding the announcement of the defaulting loan. Interestingly, we find that these results are even stronger if the defaulting firm had a strong and/or long-standing relationship with its lead lender. We also find that the negative bond market effect is particularly strong if the defaulting loan is an important deal to the lender, if it is a recently originated loan, and if the borrower has better governance, higher profitability and higher firm value in the loan origination year. In contrast, the negative bond market effect is weakened if the affected firms have more intensive analyst coverage and higher firm values. Taken together, these results strongly confirm the existence of a cross-monitoring effect between bank debt and public debt.

Keywords: Loan Contracting, Bond Market Returns, Cross Monitoring

JEL Classification: G30, G33