In our paper Do Shareholder Rights Affect the Cost of Bank Loans? which was recently accepted for publication in the Review of Financial Studies, we analyze the relationship between firm-level corporate governance measured by the governance index of Gompers, Ishii, and Metrick (2003, henceforth GIM) and the cost of bank loans issued to publicly traded firms.
We use a panel data set of over 6000 loans issued to a wide cross-section of US firms between 1990 and 2004 as the basis for our analysis. Our basic result shows that firms that are more vulnerable to takeovers (i.e., firms with higher shareholder rights) are charged significantly higher loan spreads. To quantify this result, we follow GIM and construct corner portfolios of firms with the highest (democracy) and the lowest levels (dictatorship) of shareholder rights. We show that for a typical firm in our sample a switch from the democracy to the dictatorship portfolio decreases the expected loan spread by almost 25% (30 basis points) after controlling for the default risk as well as various firm-level factors and specific features of loan contracts.
In interaction regressions, we find that democracies with low leverage are charged significantly higher loan spreads. This provides evidence that the possibility of an increase in financial risk is an important consideration through which takeover vulnerability gets priced in bank loans. Additionally we find that conditional on high takeover vulnerability, long maturity loans have higher spreads than loans with short maturities. Loans with longer maturity expose banks to takeover risk for a longer time-period and our results indicate that banks charge a premium for taking such risks.
Though our focus remains on debt pricing, bank loan covenants and collateral can also mitigate a bank’s concern about potential losses in takeover. Consistent with this argument, we find that banks charge higher loan spread to those high takeover vulnerability borrowers that have fewer covenants or those who obtain unsecured loans. To investigate whether banks can also protect their interests by having bargaining power over their borrowers, we analyze the effect of syndicate size on the pricing effect of takeover vulnerability. We find that the effect of takeover vulnerability is significantly higher for loans with smaller syndicate size i.e., when the bargaining power is likely to be high. Thus, the bargaining power channel is less likely to explain away our results.
Our results have important implications for understanding the link between a firm’s governance structure and its cost of capital. Our study suggests that firms that rely too much on corporate control market as a governance device are punished by costlier bank loans. The full paper is available for download here.