Essays on bank loan contracts

Jensen and Meckling (1976) depict the firm as a nexus of financial contracts that offer optimal mechanisms to mitigate various frictions between agents, e.g., equity holders versus debt holders, principal versus agent, etc. In this study, we focus on two particular types of loan contract, performance pricing and revolving line of credit.;Chapter 1 examines how default risk and accounting quality of borrowers affect the likelihood of using performance pricing in bank loan contracts. Consistent with the notion of negative hedging, higher default risk firms are less likely to use performance pricing loans. We also find that firms with poorer accounting quality are less likely to receive performance pricing loans. Stronger lender-borrower relationship that would mitigate information asymmetry and enhance monitoring, is found to be associated with greater likelihood of using performance pricing loans. In addition, we find that conditional on using performance pricing loans, firms with lower (higher) accounting quality are more likely to receive credit rating (accounting) based performance pricing provision. Furthermore, we document that the likelihood of receiving performance pricing loans is significantly reduced after borrowers' accounting quality deteriorates, e.g., after they restate their financial reports. These results supports the positive accounting theory, suggesting that a significant cost associated with performance pricing loans is borrowers' incentives to manipulate accounting information so as to obtain a lower loan spread.;Theoretical literature suggests that firms use lines of credit as a liquidity insurance to secure a desirable investment level in the event of future downturn (Tirole, 2005). In Chapter 2, we examine whether lines of credit provide liquidity insurance or simply convenience to firms via focusing on the drawdown rate. We find that drawdown rate is on average significantly lower than the imputed market rate on a bank loan given the financial condition of a firm at the time of drawdown, which supports the theoretical notion that lines of credit offer liquidity insurance. In addition, we document that stronger (or existence of) prior lending relation is associated with a lower drawdown rate, however bank reputation has no impact on the drawdown rate. Furthermore, we find that the impact of lending relation on the drawdown rate only exists in borrowers subject to greater information asymmetry. While we document that borrowers are penalized (paying a higher spread and more likely pledging collateral) on new lines of credit issued after their drawdown, they are penalized much less as they borrow from high reputation banks. Our results suggest that bank reputation and lending relation help provide a more efficient liquidity insurance, however via different channels.;Chapter 3 examines how a firm's performance pricing loans affect manager's incentive to manipulate earning. We find that firms with a greater slope or convexity in their performance pricing loans have significantly larger discretionary accruals. However, the positive association between the slope or convexity of PSD and discretionary accruals is significantly reduced as the lenders are of higher reputation or have had a prior lending relationship with the borrowers. These results suggest that bank reputation and prior lending relation serve as an effective monitoring mechanism, which in turn mitigates managers' incentive to manage earnings.