An analysis of the monitoring ability of commercial banks with two applications in loan contracting

The three essays in this dissertation are unified by a common question which defines commercial banks as financial intermediaries that offers a unique service. The central hypothesis is that this unique service is the level of monitoring that banks perform for their clients. To explore this question, the research presented here looks at banks as a heterogeneous group where each individual bank differs in its ability to monitor its borrowers. The empirical question is, "How does the ability of a commercial bank to monitor its borrower affect the relationship between the lender and the borrower?" By observing how varying monitoring ability affects bank-borrower relationships, the special nature of monitoring is examined. Insight into this question is gained by asking the following three more specific questions. First, do markets perceive a difference in the monitoring ability of commercial banks? Second, what types of firms contract with banks that have superior monitoring ability? Lastly, how does the monitoring ability of the commercial bank alter the type of loan contract between the borrower and lender?;Essay one uses OLS to examine the ability of proxies for active monitoring ability on the part of commercial banks to explain excess returns following loan announcements. Essays two and three use logistic regression to explain the differences in types of borrowers that contract with superior monitoring banks and the types of contracts written between borrowers and superior banks respectively. Results from the first essay provide the first test of metrics from theoretical literature that indicate monitoring ability and show that monitoring ability is a heterogeneous quality among banks. Furthermore, this quality affects investors' perception of the loan announcement. Evidence from the second essay shows borrowers that are higher risk, more opaque, and more likely to enter public markets are all more likely to contract with superior monitoring banks. From the final essay, the main results indicate that contracts with superior monitors are likely to be more flexible and contain provisions for collateral. Taken as a whole, the results indicate that monitoring is a special service that commercial banks provide to their clients.