A New View of Loan Contracts

Banks write stricter loan contracts for risky borrowers in an effort to overcome the risks they present. According to research by Justin Murfin, assistant professor of finance, banks also write stricter contracts when they are trying to overcome risks that they bring to the table as well.

Murfin, who joined the Yale SOM faculty in July, studies empirical corporate finance. His current work links corporate finance decisions to events in the bank market. In a recent study, Murfin looked at the loan contracts borrowers receive. The standard approach to analyzing these contracts is from the perspective of a borrower's characteristics. For example, riskier borrowers or those who don't have a lot of collateral require much stricter contracts from a lender. Murfin flipped this approach, examining whether there are bank characteristics that can explain how a contract is structured.

"What I found is a little bit surprising," says Murfin. "Lenders write much stricter contracts to their borrowers after they have suffered large defaults to their portfolios. Imagine two banks writing loans to equivalent borrowers, at the same point in time, in the same macroeconomic conditions. A lender who has recently had a really bad quarter is going to write a much stricter contract for their borrower than the lender who didn't."

Murfin attributes this to lenders learning about their ability to screen borrowers. "As the chief credit officer, I start to worry if I have a large loss and my rival banks don't. What am I doing? Are my officers poorly trained? Are my credit models broken? Until I can fix the problem I want to write much stricter contracts for my borrowers so I can keep them on a tighter leash and renegotiate more frequently." 

Murfin's interest in loan contracts started at Barclays Capital. "I was writing loan contracts and was intellectually curious about why the contracts were the way that they were and started hunting around on the internet to find what the academic literature could tell me. I bumped into papers written by Manju Puri, who later became my doctoral advisor at Duke, and my eyes lit up. People on the academic side were also interested in these questions. Ultimately that motivated me to get my PhD."

Murfin is currently doing preliminary work around trade credit, the option to finance the purchase of goods that a supplier extends to a buyer. He is studying the effect of this financing between big box retailers and their smaller suppliers.

"If we look at the balance sheet of a firm like Walmart, they're getting a lot of financing from much smaller suppliers, who, in many cases, are themselves credit constrained. This is an important puzzle."

Murfin says that when big box retailers decide to pay firms a little bit later as a working capital initiative at the retail level, it has a huge effect on the operations of the manufacturers that are selling to them.

"We show that one standard deviation change in how long a firm like Walmart, Target, or Costco takes to pay has an effect on investment for these suppliers which is comparable in magnitude to having several years in a row of negative earnings."