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Competition or Collaboration? The Reciprocity Effect in Loan Syndication

Competition or Collaboration? The Reciprocity Effect in Loan Syndication. Jian Cai Washington University in St. Louis The 45 th Annual Conference on Bank Structure and Competition May 6-8, 2009  Chicago. The Syndicated Loan Market.

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Competition or Collaboration? The Reciprocity Effect in Loan Syndication

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  1. Competition or Collaboration?The Reciprocity Effect in Loan Syndication Jian Cai Washington University in St. Louis The 45th Annual Conference onBank Structure and Competition May 6-8, 2009  Chicago

  2. The Syndicated Loan Market • The syndicated loan market has experienced tremendous growth and become an increasingly important source of corporate finance since the early 1990s In the U.S. Increased 6 times(CAGR = 15%) Outside the U.S. Increased 30 times(CAGR = 28%) The Reciprocity Effect in Loan Syndication

  3. An Inherent Agency Problem • A syndicated loan is a credit facility two or more lending institutions jointly agree to provide to a borrowing firm • Two types of syndicate members: lead arranger(s), participant Lenders • Bank screening and monitoring is a key economic function of banks in relationship lending according to contemporary financial intermediation theories; these responsibilities are mainly delegated to lead arrangers • Associated with loan syndication, we observe the following: • “Informed” lead arrangers vs. “uninformed” participant lenders • Costly but often unobservable due diligence and monitoring effort • Diluted incentive for lead arrangers to monitor their borrowers • Syndication introduces an agency problem – possibility of opportunistic behavior by lead arrangers The Reciprocity Effect in Loan Syndication

  4. Research Question • However, there has been little empirical evidence of such opportunistic behavior • A larger portion of “quality” loans are syndicated [Simons (1993)] • Agency problems do not prevail in loan syndications [Panyagometh and Roberts (2002)] • Default rates in the syndicated loan market are quite low [Sufi (2007)] Question: How does the syndicated loan market overcome the obvious agency problem? The Reciprocity Effect in Loan Syndication

  5. Two Existing Explanations 1. The Incentive Effect 2. The Reputation Effect The lead arranger retains a larger share of the loan that presents more severe info asymmetry and requires more intense monitoring and due diligence Reputation concerns of the lead arranger mitigate the agency problem in loan syndication; a more reputable lender is more likely to syndicate loans, etc. • Opaque Borrowers • Less Reputable lead arrangers The Reciprocity Effect in Loan Syndication

  6. Lead Arrangers = Participant Lenders? • In the U.S. market, 77% of lead arrangers also participate in loans • The largest lead arrangers are indeed the largest participant lenders The U.S. Syndicated Loan Market, 2004-2006 Top 10 Lead Arrangers: 1. JPMorganChase 2. Bank of America 3. Citigroup 4. Wachovia 5. Deutsche Bank 6. Credit Suisse 7. Wells Fargo 8. GE Capital 9. UBS 10. ABN AMRO Top 10 Participant Lenders: 1. Bank of America 2. Wachovia 3. JPMorganChase 4. ABN AMRO 5. Wells Fargo 6. U.S. Bancorp 7. GE Capital 8. Citigroup 9. National City Corp. 10. Royal Bank of Scotland The Reciprocity Effect in Loan Syndication

  7. Who Participate in Whose Loans? • Lenders often maintain stable relationships with certain other lenders and rotate their roles between leading and participating The U.S. Syndicated Loan Market, 2004-2006 JPMorganChase 28% 52% 30% 39% 17% Bank of America Citigroup 47% The Reciprocity Effect in Loan Syndication

  8. A Novel View: The Reciprocity Effect • Syndicate arrangements are reciprocal • I show that such reciprocal arrangements serve as an effective mechanism to mitigate agency conflicts in loan syndication Reciprocal arrangements → Reciprocity shared among lead arrangers→ The reciprocity effect • The key to the cooperative equilibrium is the punishment/threat of not inviting lead arrangers whose loans previously failed OpportunisticBehavior Due Diligence & Monitoring LoanDefault  LoanDefault  Unable to Participate Able to Participate The Reciprocity Effect in Loan Syndication

  9. Empirical Prediction • Reciprocal participation gives the lead arranger additional incentive to act in the interest of the entire syndicate and hence induces the lead arranger to exert the desired monitoring effort Prediction: The moral hazard problem is reduced among loans whose lead arrangers share reciprocity with one or more participant lenders; this reduced moral hazard results in: (i) a smaller share of the loan retained by the lead arranger, (ii) a lower interest rate charged to the borrower, and (iii) a lower probability of loan default. The Reciprocity Effect in Loan Syndication

  10. Empirical Evidence • Controlling for borrower, lead arranger, and loan characteristics, I show that for loans with reciprocity: • Lead arrangers retain on average 4.3% less of the loan • The average interest spread over LIBOR on drawn funds is 11 basis points lower • The default probability is 4.5% lower • These results are both statistically and economically significant and robust to various specifications • The reciprocity effect also exists for (i) informationally-opaque borrowers, (ii) smaller borrowers, (iii) smaller loans, (iv) less reputable lead arrangers, and (v) less reputable borrowers The Reciprocity Effect in Loan Syndication

  11. Definition of Reciprocity • Focus here is on current reciprocity; results also hold for other forms • Total reciprocity vs. reciprocity at origination(ex post vs. ex ante) • Total reciprocity: reciprocity over the entire sample period • Reciprocity at origination: reciprocity in existence at loan origination  used in all empirical analyses for testing the reciprocity effect Loan A Loan B Reciprocity Bank A (Lead) Bank B (Participant) Bank B (Lead) Bank A (Participant) Current Reciprocity Past & Future Reciprocity The Reciprocity Effect in Loan Syndication

  12. Measures of Reciprocity • Data sources: DealScan, Compustat, and bankruptcies data • Sample: 46,448 syndicated loan facilities originated for non-financial U.S. firms from 1992 to April 2007 * All statistics are means and for current reciprocity at origination only. The Reciprocity Effect in Loan Syndication

  13. Regression Specification • Existence • Breadth • Depth • Length • Lead share • Interest spread • Loan default Robust standard errors allowing for clustering within borrowers/leads/borrower-lead groups The Reciprocity Effect in Loan Syndication

  14. The Reciprocity Effect The Reciprocity Effect in Loan Syndication * significantly different from zero at the 10% level, ** at the 5% level, and *** at the 1% level.

  15. Economic Significance • Average lead share = 29.5% • Average loan amount = $217 million • Average maturity = 50 months • Average interest spread = 221 basis points • Default rate (1992-2001) = 9.1% • 4.3% less of the loan: • A reduction of 15% • $9 million savings per loan • 11 basis points lower: • A reduction of 5% • $238,700 savings per year • $994,583 savings in total • 4.5% lower chance of default: • A reduction by half The Reciprocity Effect in Loan Syndication

  16. Conclusion • Examined reciprocity in loan syndication and its effect in resolving agency conflicts between lead arrangers and participant lenders • Uncovered strong and consistent empirical evidence that lead arrangers’ moral hazard is mitigated by the prevalent existence of reciprocity in syndicated loans  important implications: • To lending institutions, smaller shares retained of loans they lead, thus less capital tied to individual loans and better risk diversification • To borrowing firms, lower borrowing costs, which may explain why the syndicated loan market has grown so fast in recent years • To regulators, lower default rate, which may improve social welfare The Reciprocity Effect in Loan Syndication

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