Bank Compensation for Penalty-Free Loan Prepayment: Theory and Tests

Karin Thorburn (karin.thorburn@nhh.no), Bjorn Eckbo (b.espen.eckbo@dartmouth.edu) and Xunhua Su

No 16300, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: While institutional tranches in term loans typically include a cancellation fee, commercial banks allow penalty-free prepayment in 90% of their tranche-A loan facilities. We show that compensating banks for a penalty-free prepayment option by raising the initial loan rate increases the prepayment risk and may result in credit rationing. However, combining a lower loan rate with an upfront fee allows the bank to break even. Empirically, upfront fees increase in prepayment risk and are lower in credit lines and performance-sensitive debt, as predicted. Moreover, high industry merger intensity, which exogenously increases prepayment risk, further raises the upfront fee.

Keywords: Credit rationing; Upfront fee; Prepayment risk; Performance-pricing; Cancellation fee (search for similar items in EconPapers)
JEL-codes: D82 D86 G21 G32 (search for similar items in EconPapers)
Date: 2021-06
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