Competition or Collaboration?The Reciprocity Effect in Loan Syndication

Jian CaiWashington University in St. Louis

The 45th Annual Conference onBank Structure and Competition

May 6-8, 2009 Chicago

The Syndicated Loan Market

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In the U.S. Increased 6 times

(CAGR = 15%) Outside the U.S.Increased 30 times

(CAGR = 28%)

• The syndicated loan market has experienced tremendous growth and become an increasingly important source of corporate finance since the early 1990s

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

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Research Question

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However, there has been little empirical evidence of such opportunistic behaviorA 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?

Two Existing Explanations

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1. The Incentive 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

2. The Reputation Effect

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

Lead Arrangers = Participant Lenders?

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In the U.S. market, 77% of lead arrangers also participate in loans

The largest lead arrangers are indeed the largest participant lenders

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

The U.S. Syndicated Loan Market, 2004-2006

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

Who Participate in Whose Loans?

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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

Bank of America Citigroup

28%39%

52%30%

47%

17%

A Novel View: The Reciprocity Effect

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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

LoanDefault

Unable to Participate

Due Diligence & Monitoring

LoanDefault

Able to Participate

Empirical Prediction

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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.

Empirical Evidence

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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

Definition of Reciprocity

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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 periodReciprocity at origination: reciprocity in existence at loan origination

used in all empirical analyses for testing the reciprocity effect

Loan A

Bank A (Lead)Bank B (Participant)

Reciprocity

CurrentReciprocity

Past & FutureReciprocity

Measures of Reciprocity

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* All statistics are means and for current reciprocity at origination only.

• 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

Regression Specification

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jitkji nAsymmetryInformatioyReciprocitSyndicate 210,,,

kk ticsharacterisOtherLeadCtionLeadReputa 43

tkjiti ,,,7 YearteristicsLoanCharac

jj eristicswerCharactOtherBorroputationBorrowerRe 65

• Lead share• Interest spread• Loan default

• Existence• Breadth• Depth• Length

Robust standard errors allowing for clustering within borrowers/leads/borrower-lead groups

14 Bank Structure Conference, May 2009The Reciprocity Effect in Loan Syndication

The Reciprocity Effect

* significantly different from zero at the 10% level, ** at the 5% level, and *** at the 1% level.

Economic Significance

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• 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

Conclusion

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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