Penalty-Free Prepayments, Credit Rationing, and the Use of Upfront Fees in Bank Loans

We show that the use of non-interest terms in bank loans is a way to maintain the borrowers' flexibility to prepay freely. If voluntary prepayments are penalty-free, as widely observed for bank loans in practice, over time good borrowers prepay their loans while bad borrowers stay. This reclassification effect leaves the lender with bad borrowers only. Increasing the interest rate is not sufficient to compensate the lender for the prepayment risk, so the bank resorts to non-interest credit rationing. In addition to non-price instruments such as collateral, a non-linear pricing approach, in which the loan price is split into the interest and the upfront fee, can be employed. The model predicts that: higher loan prices and lower refinancing costs are associated with higher upfront fees; secured loans use higher upfront fees, but performance-sensitive loans use lower. Empirical evidence supports these predictions. Using a sample of 29,510 term loans to U.S. firms between 1992 and 2011, we find that a 100 basis points increase in the loan spread leads to an average increase in the upfront fee by over 15 basis points. Loans with higher refinancing costs, unsecured loans and performance-sensitive loans are in general associated with lower upfront fees.