DP16300 Bank Compensation for Penalty-Free Loan Prepayment: Theory and Tests
|Author(s):||B Espen Eckbo, Xunhua Su, Karin S Thorburn|
|Publication Date:||June 2021|
|Keyword(s):||cancellation fee, Credit rationing, performance-pricing, prepayment risk, upfront fee|
|JEL(s):||D82, D86, G21, G32|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=16300|
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.