A Comparison of Syndicated Loan Pricing at Investment and Commercial Banks

Harjoto, Maretno, Mullineaux, Donald J., Yi, Ha-Chin, Financial Management

We reject the hypothesis that investment and commercial banks have identical loan-pricing policies. We find that compared to commercial banks, investment banks lend to less profitable, more leveraged firms, price riskier classes of term loans more generously, and offer relatively longer-term credits, usually with term, not commitment contracts. Investment banks typically establish higher credit spreads, although the premium declines when a commercial bank joins as syndicate co-arranger. Investment banks also price riskier classes of term loans more generously to borrowers than do commercial banks. Commercial-bank funding advantages do not appear to be a source of the pricing differences.

In recent years, commercial banking organizations have gained a substantial share of the market in securities underwriting. A number of studies, such as Gande, Puri, Saunders, and Walter (1997), show that bank holding companies' entry into this area has influenced the pricing of new issues, underwriting fees, or both. Perhaps as a competitive response to "turf invasion" by commercial banks, investment banks entered the commercial lending business, placing their primary emphasis on syndicated loans. From 1996-2003, investment banks led over 1,300 commercial loan syndications, raising almost $768 billion in funding. However, there has been little research on this development. The primary objective of our study is to determine whether syndicated loans originated by investment banks are priced differently from those arranged by commercial banks.

In this article, we estimate models for credit spreads on syndicated loans originated by investment and commercial banks. We first examine whether spreads are relatively higher or lower at investment banks, assuming that the same model generates the outcomes. Our measure of spread captures fees as well as loan rates. We find that investment banks charge higher spreads than do commercial banks, ceteris paribus, on both term and revolving loans (revolvers). We also find that loan pricing is affected when investment and commercial banks act as co-arrangers in a loan syndication. We then relax the assumption that the same process across institution type determines spreads and find evidence that loan pricing processes differ at investment and commercial banks. Investment banks appear to charge less on the margin for assuming credit risk, for instance.

In Section I, we consider why loan pricing could differ for syndicated loans originated by investment banks rather than by commercial banking organizations. Section II describes the data and presents the results of various model estimations. Section III presents some robustness analysis and Section IV concludes.

I. Why Loan Pricing Might Differ

There are several important distinctions between investment and commercial banks that may have implications for loan pricing. Investment and commercial banks differ in at least five ways: (a) sources of funds, (b) regulation, (c) the relevance of customer relationships, (d) prospects for economies of scope, and (e) the relevance of accounting rules. We briefly consider the roles of each from a loan-pricing perspective.

A. Sources of Funds

For commercial banks, deposits are relatively inexpensive, reliably stable sources of funds. Core deposits have low rates primarily because they are, for the most part, insured and hence risk-free. However, the default-free status of deposits brings both explicit and implicit costs. The explicit costs are deposit insurance premiums and the implicit cost is the regulatory burden imposed on banks to preserve the viability of the FDIC. These associated costs of deposits offset at least some, if not all, of the benefits of their low interest expense.

Unlike commercial banks, investment banks cannot accept deposits. However, some investment banks have gained access to insured deposits by acquiring or chartering banks or bank-like organizations. For example, Merrill Lynch, Morgan Stanley, and Lehman Brothers each have a commercial bank or bank-like subsidiary. As of April 30, 2003, Merrill Lynch reports holding over $70 billion of deposits at its two banking subsidiaries. Merrill Lynch Bank USA is actually chartered as an industrial loan company in Utah, but these institutions, like banks, are regulated by the FDIC. Morgan Stanley Bank is also chartered as an industrial loan company. Lehman holds a federal savings bank charter. We examine whether these particular institutions price loans differently from those without deposit access.

Almost all large commercial banks are subsidiaries of holding companies, which might substantiate another funding advantage for commercial over investment banks. Houston and James (1998) find that lending by banks affiliated with holding companies is less constrained by cash flow, liquidity, or capital positions when compared to lending by unaffiliated banks, for instance. Most of the investment bank lenders in our sample are not affiliated with bank holding companies. Hence, they lack access to the internal capital markets that serve to alleviate bank lending constraints. However, we notice that some investment-bank lenders in our sample are subsidiaries of bank holding companies. We include them with commercial bank lenders in our estimations on the grounds that they are likely to apply the monitoring technology of the commercial bank in the holding company. However, in our empirical work we examine whether this assumption is valid.

Without access to deposit and internal capital markets, investment banks must fund loans in the money and capital markets, where interest costs routinely exceed deposit rates. Consequently, investment banks might charge higher loan rates, fees, or both, because they face higher costs of "raw materials".

Commercial banks have an additional deposit-based benefit: the information they gain from administering these accounts can facilitate their capacity to monitor borrowers (see Mester, Nakamura, and Renault, 2006). By providing payment services, banks gain a stronger sense of the firm's operational and financial activities, which facilitates loan contracting and perhaps allows commercial banks to establish lower loan rates than can investment banks.

B. Regulation

Commercial banks are more regulated than investment banks, primarily because they accept insured deposits. Commercial banks must maintain required reserves on transactions deposits, and this regulation lowers the expected return on lending. (1) Commercial bank lenders also must "back" their loans with equity and other forms of bank capital, which are relatively expensive sources of funds. The required equity component on commercial loans equals at least 4% of the amount of the loan. However, the capital requirement does not apply to loan commitments with a maturity of 364 days or less.

Because investment banks are not subject to the regulatory taxes associated with reserve and bank capital requirements, they can offer lower interest rates, or fees, or both, on loans. The net effect of the impact of differences in funding sources and differences in regulation on the relative loan rates charged by investment and commercial banks is consequently unclear, a priori.

C. Relevance of Relationships

Many studies emphasize the relevance of relationships in commercial-bank lending. (2) In these papers, the value of a lender/borrower relationship has multiple sources. In some cases, a relationship is the result of repeat transactions that allow lenders to learn more about borrowers over time, thus attenuating information asymmetry and adverse selection problems. Borrowers with extensive bank relationships therefore should receive lower rates on their loans. Berger and Udell (1995) find evidence for this hypothesis, but Petersen and Rajan (1994) do not. Blackwell and Winters (1997) report similar findings for the influence of "relationship" on loan rates. Degryse and Ongena (2001) find that firms with strong bilateral banking relationships tend to be more profitable than those without such ties.

Boot and Thakor (2000) contrast "relationship banking" with "transaction banking." The latter involves arm's length transactions and is capital-market-like in quality. These authors argue that relationship loans are more costly to produce than transactions loans, which would imply higher rates and/or fees on such loans. They note that commercial banks engage in both types of lending and, to some extent, the same might be said of investment banks.

We conjecture that investment banks will focus more on transactions than on relationship loans since they are new to syndicated lending and historically have specialized in transactions-based finance. Our data show that investment banks prefer term loans to revolving credits, which is consistent with this view. Investment banks also are more likely than commercial banks to sell loans in the secondary market, and such sales can diminish the value of relationships.

However, the implications for relative loan pricing are ambiguous. Relationship loans are more expensive to generate than transactions loans, but the information acquired in a relationship context may allow a more accurate measurement of default risk. This reduction in uncertainty could result in lower rates on relationship than transaction loans, ceteris paribus, at least for relatively high-quality borrowers. If the net benefits of relationships are captured mainly by borrowers, then commercial banks should charge lower rates on loans than investment banks.

D. Economies of Scope

Banks may offer lower loan rates to borrowers who purchase a package of additional services, such as cash management, pension management, or underwriting services. The capacity to offer discounts in this context is often associated with economies of scope in production. Kanatas and Qi (1998, 2003) and Puri (1999) show how these economies can rationalize lending and underwriting combinations, but scope-based cost advantages can apply broadly across the product set offered by lenders. The impact on loan pricing is again ambiguous since, as Kanatas and Qi (2003) and Puri (1999) note, scope economies also could result in market power and some capacity to influence prices. Drucker and Puri (2005) report evidence of scope economies in commercial lending and underwriting, based primarily on the reusability of information, that works to the advantage of both commercial and investment bank customers. Although there are numerous studies on scope economies in commercial banking, we find only a few papers on scope economies in investment banking, almost all of which addressed the benefits and costs of universal banking. Although commercial banks and investment banks are both likely to offer bundled products, we surmise that the current menu of bundled services is larger at commercial banks than at investment banks.

E. Accounting Rules

Accounting rules require that loans "held for sale" must be marked to market. Because investment banks lack a core deposit base, their loans are generally sold in the secondary market and are routinely marked to market. A much smaller portion of bank loans are designated held for sale; the remainder are subject to book value accounting. Consequently, investment banks face more market risk in their lending operations than commercial banks. (3) Thus, investment banks might require higher expected returns on their loans …

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Publication information: Article title: A Comparison of Syndicated Loan Pricing at Investment and Commercial Banks. Contributors: Harjoto, Maretno - Author, Mullineaux, Donald J. - Author, Yi, Ha-Chin - Author. Journal title: Financial Management. Volume: 35. Issue: 4 Publication date: Winter 2006. Page number: 49+. © 2009 Financial Management Association. COPYRIGHT 2006 Gale Group.

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