Monitoring with Small Stakes

Abstract

This paper proposes a mechanism to address the “monitoring with small stakes” puzzle in syndicated lending. We identify two sources that incentivize creditor monitoring: “skin in the game” and rent extraction from renegotiation. Renegotiation-based rent extraction serves as a substitute to banks’ loan stakes, facilitating institutional investors’ participation in syndicated lending. We use the passage of a tax policy that exogenously reduced renegotiation frictions to empirically identify this mechanism. we find that a less frictional renegotiation environment leads to more diligent monitoring, smaller bank shares in new loans, and improved borrower performance, particularly in pre-existing deals with lower bank shares.