Who Is Minding The Loans?

Changes in the corporate finance world are shaking up the banks’ role as senior lenders

The Essentials

Banks, acting as senior lenders, used to be counted on to closely monitor their loans, and all investors benefited. But with the rise of the shadow banking system and growth in bond offerings, banks are losing their special place in the corporate finance ecosystem. In this QSB Insight TALKS presentation filmed at Queen’s Grant Hall, Lynnette Purda discusses what these trends might mean for borrowers and capital markets. Purda is associate professor and RBC Fellow of Finance at Queen’s School of Business.

Video Highlights

0:35     How corporations are obtaining debt is changing with the growth of bond markets and involvement of non-bank lenders. Almost 70 percent of corporate financing now comes from debt: 25 percent from banks, 11 percent from the shadow banking system, and 29 percent from bonds. “The bond market is becoming a much larger part of how companies are financing their operations.”

3:28     Traditional banking loans almost always involve covenants and are given the highest priority over other debt. By contrast, bond issues rarely involve covenants and, when they do, violations are not well enforced. As a result, banks have an incentive to carefully monitor each loan; have a cost advantage in monitoring borrowers; and have greater power to change borrower behaviour. With the shift away from traditional bankers towards new sources of debt, do we lose the benefits that come from banks closely monitoring their loans?

7:52     Investors benefit by having banks closely monitor their lending relationships. Research from the early 2000s, for example, showed that stock prices respond positively when banking relationships are announced. More recent research indicated that stock holders continue to benefit from bank loans even after the bank sells the loan to other investors. When banks sell their loans, does it change the incentive to monitor lenders? “Where we used to say there was something special about the banks and that something spills over to all other investors, now we’re questioning that.”

10:24     Conflict among creditors is on the rise. “The devil side [of banks] is coming out. . . They use their covenants, existing relationships, and senior lender status to protect their own interests at the expense of other lenders. And because the parties that are involved are changing and becoming larger relative to the banks, there’s greater opportunity for creditor conflict.” There are also conflicts of interest. Senior lenders acting out of self-interest, for example, can push a struggling firm to liquidate even if the firm has a decent chance of righting itself. 

12:40     Research by Purda and Queen’s colleagues are examining the influence of bank power on bondholders in the absence of financial distress. They are finding that bondholders are well aware of the potential abuse of power by senior bank lenders; they demand higher bond interest rates, for example, when banks hold strong covenants. “But we haven’t found evidence of bank monitoring benefits or the good side of the banks spilling over to the bondholder.”

15:46      Questions going forward: Are changes in corporate finance compelling banks to change their loan monitoring behaviour? Do lenders factor in potential conflicts between one another in the rate they charge to borrowers? “The implications are huge for companies that are involved. Agreeing to strict bank terms may, in fact, influence the terms that they have on other kinds of capital they receive.”