Topic and Objectives
The terms of financial contracts are often negotiated and such negotiations take place in markets where assets are traded over-the-counter. These include the mortgage-backed securities, corporate bond, municipal bond, corporate takeover, bank loan, private equity, and real estate markets. In negotiations, parties could make offers and counteroffers to try to reach a deal. Strategic bargaining theories show that price adjustments over the course of the negotiation could elicit private information. Although bargaining is important in financial markets, little is known about the use of negotiating as a screening mechanism. The main reason for this lack of evidence is that existing studies rely on financial contract data, because real world negotiations take place in private meetings, on the phone or by e-mail, and are usually not centrally recorded. Therefore, an important empirical challenge is that financial contracts do not reveal whether the terms were set in a single offer based on observable risk, or rather are the outcome of a negotiation process.
In this paper, I propose and test a model of credit negotiations between banks and firms. The model shows that price negotiations allow banks to screen out firms by making sequential credit offers over the course of the negotiation. The model generates empirical predictions, which I test using a unique dataset on credit line negotiations between small firms and a large commercial bank, including both rejected and accepted offers and the ex post performance of these lines of credit. In the model, firms negotiate with a bank about the interest rate of a new credit line. The model provides the following empirical predictions: first, if banks use negotiations to screen out firms, we should observe variation in the negotiation length, even across firms with similar observable characteristics. Second, the likelihood of price adjustments should increase the length of the negotiation. Third, the negotiation length should predict the ex post use and performance of the line of credit. Fourth, if this screening mechanism is effective, firms negotiating price adjustments are less likely to draw down their line of credit and default less, when holding observable differences at origination constant. To test these predictions, I use a novel dataset on 16,717 credit line negotiations between small firms and a large commercial bank for the period from January 2008 to December 2011.
- Consistent with the screening hypothesis, firms that negotiate longer are more likely to negotiate interest rate and fee adjustments: only seven percent of the firms reaching an agreement in one week negotiate an all-in-spread decrease, while 20 percent of the firms reaching an agreement in four weeks or more negotiate an all-in-spread decrease.
- When comparing firms that received offers with identical terms, I find that firms signing the offer immediately use their line of credit and default more than late signers. Immediate signers use their line of credit one year after origination, which is 10 percentage points more than firms that reach an agreement after 20 days and received a first offer with the same credit term package. Further evidence shows that immediate signers already start using their line of credit more right after origination, suggesting that they had an urgent need for extra liquidity. In line with the model, firms seem to trade-off direct access to their new line of credit against a higher price.
- Next, I investigate whether price adjustments predict ex post credit line use. In a symmetric information setting, firms signing an offer with better pricing terms have price incentives to use their line of credit more often. Firms negotiating price adjustments use their line of credit 10 percentage points less than firms accepting the offer of the bank without credit term changes. In addition, these firms default less.
|211||Thomas Mosk||Bargaining with a Bank||2018||Financial Intermediation||Credit lines, Contract terms, Bargaining, Screening|