Monitoring with Small Stakes

Abstract

This paper proposes a mechanism to address the issue of "monitoring with small stakes" in syndicated lending. We identify two sources that incentivize creditor monitoring: skin-in-the-game and rent extraction from renegotiation. Renegotiation-based rent extraction serves a substitute to banks' loan stake for monitoring incentives, facilitating institutional investors’ participation in syndicated lending. We use the passage of a tax policy that exogenously reduced renegotiation frictions to identify this channel. Our findings suggests that a less frictional renegotiation environment leads to more diligent monitoring, smaller bank shares in new loans and improved borrower performance, particularly in pre-existing deals with lower bank skin-in-the-game.

Keywords: contract theory, monitoring, institutional loans, cov-lite, covenants, fiscal policy, control rights, leveraged loans

JEL Classification: G21, G23, G30