Bank Compensation for Penalty-Free Loan Prepayment: Theory and Tests

Bank Compensation for Penalty-Free Loan Prepayment: Theory and Tests

B. Espen Eckbo, Xunhua Su, Karin Thorburn

Series number :

Serial Number: 
770/2021

Date posted :

July 01 2021

Last revised :

July 01 2021
SSRN Share

Keywords

  • credit rationing • 
  • upfront fee • 
  • borrower risk • 
  • performance-pricing • 
  • security • 
  • collateral

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.

Authors

Real name:
Xunhua Su